Southmark Corporation v. Jeffrey Cagan and Cagan Realty, Inc., as Court-Appointed Receiver for Equity Builders Incorporated and Riviera Utilities of Arkansas, Inc.
Docket: 92-2542
Court: Court of Appeals for the Seventh Circuit; August 19, 1993; Federal Appellate Court
Southmark Corporation initiated a foreclosure action against Jeffrey Cagan and Cagan Realty, Inc., who were appointed as receivers for Equity Builders, Inc. The case arose after Southmark sold property known as Diamondhead to Equity Builders. Cagan claimed the mortgage was part of a fraudulent Ponzi scheme orchestrated by Southmark and Equity's officers, arguing that this should prevent foreclosure under Arkansas' fraudulent conveyance statute. The district court granted summary judgment in favor of Southmark, concluding that Equity was not harmed and that Cagan lacked standing to claim fraud on behalf of the partnerships.
However, the appellate court found significant factual disputes that precluded summary judgment, indicating the need for further examination of how the partnerships funded Equity's interest and whether Southmark conspired to misappropriate funds. The court reversed the lower court’s decision, ordered consolidation of this case with a related lawsuit filed by Cagan and the Diamondhead investors against Southmark, and emphasized the complexity of the underlying facts involving a network of real estate investments managed by Kenneth Boula and Earl Dean Gordon through limited partnerships.
Gordon and Boula misled investors regarding the profitability of their real estate projects, promising steady income while engaging in a Ponzi scheme that used newer investments to pay returns to earlier ones. They attracted investors by claiming to develop specific properties, but instead financed struggling partnerships with the funds. In 1984, they partnered with Southmark, a Georgia corporation that financed real estate developments, leading to a broker-dealer agreement in 1985. Financial Concepts, under their management, sold $2.1 million in Southmark partnerships, earning them recognition and bonuses.
Gordon attempted to resolve Financial Concepts' cash-flow issues by seeking Southmark's assistance, suggesting a possible takeover of Financial Concepts' properties. After a review of Financial Concepts' operations, a Southmark vice president recommended consolidating partnerships but provided little additional support. Despite being barred from selling real estate partnerships in Illinois in mid-1986, Gordon's affidavit indicates that Southmark was aware of Gordon and Boula's business practices and chose to overlook them for profit.
In 1984, Southmark purchased the Diamondhead property for $1.7 million, which included 1,000 lots and several commercial facilities. In 1987, Southmark expressed interest in selling Diamondhead, leading Gordon and Boula to agree to buy it for $3.5 million, forming a corporate entity, Equity Builders, Inc., to facilitate the transaction. Equity Builders secured the purchase with a note and a mortgage on the property.
Neither Gordon nor Boula conducted due diligence in their dealings with Southmark regarding the property Diamondhead. Southmark misrepresented the property's worth, claiming it was valued over $3.5 million, while appraisals later revealed it was significantly lower. Additionally, Southmark falsely stated it paid over $4 million for Diamondhead when the actual amount was $1.7 million. Gordon expressed indifference to the purchase price, believing he could finance it through loans from private syndications and later profit by selling lots at Diamondhead.
Southmark failed to investigate the financing methods of Gordon and Boula or the assets of Equity, the entity that acquired Diamondhead. Cagan, as receiver for Equity and Diamondhead, alleged that Southmark conspired with Gordon and Boula to defraud Equity and its investors to address mutual short-term financial needs. Equity made a $350,000 down payment for Diamondhead, which was financed by loans from banks secured by Gordon and Boula.
Between mid-1987 and early 1988, Gordon and Boula established nine partnerships to solicit investments for Diamondhead development, raising $1.1 million, of which approximately $900,000 was diverted to Southmark, while Gordon and Boula retained the remainder. It remains unclear how the funds flowed through Equity before reaching Southmark.
The situation culminated in 1988 when investors from Financial Concepts filed a securities fraud class action against Gordon and Boula, leading to Cagan's appointment as receiver for Financial Concepts in July 1988, and subsequently for the Diamondhead property in March 1989. An accountant determined that the Diamondhead partnerships were part of Financial Concepts, placing them under Cagan's receivership. The class action settled with a $30 million compensatory judgment and $2 million in punitive damages, though it is unknown if any of these funds were distributed to Diamondhead investors.
Southmark's foreclosure case concerning Diamondhead was adjudicated by Judge Nordberg in the Northern District of Illinois. The court upheld the denial of intervention by Diamondhead investors, stating that Cagan could adequately protect their interests. The court also recommended consolidation with a related fraud case against Southmark, which was declined by Judge Nordberg due to issues of creditor standing. Southmark's bankruptcy proceedings in Texas allowed Cagan to pursue claims not included in Southmark's reorganization plan due to inadequate notice.
The legal issues are centered on Southmark's foreclosure actions against Diamondhead, with Southmark arguing that Cagan lacks standing to contest the foreclosure on behalf of the Diamondhead partners and Equity. Conversely, the Diamondhead partners claim fraudulent conveyance, alleging that Southmark has previously defrauded them and is now attempting to seize property.
The district court established that receivers can only bring actions that the property owner (Equity) could bring, and noted that the Diamondhead partners had no claims against Equity, thus Cagan could not contest the foreclosure. However, the court's conclusion that the partners were not creditors of Equity was flawed. Under Arkansas law, specifically the fraudulent transfer statute, the Diamondhead partners are defined as creditors because they possess claims against Equity. This classification grants Cagan standing to seek relief on their behalf. The court's errors in interpreting creditor status necessitate a reversal of the summary judgment granted to Southmark.
Southmark's argument hinges on an accountant's affidavit asserting that the Diamondhead partners cannot be considered creditors of Equity, as Equity was merely a shell corporation until funded by the partnerships. The affidavit claims that $1,350,760 was misappropriated by the partnerships to Equity, which was never repaid, and that funds supposedly intended for the construction of rental properties were instead used to settle bank loans related to the Diamondhead purchase. However, the affidavit does not clarify the specifics of how the partners' funds were used, leaving ambiguity about whether the partners' money went directly to Gordon and Boula, to banks, or to Equity itself. It does suggest that the partners funded Equity, which then paid off the loans, leaving open the possibility that the partners could have claims against Equity.
Cagan contends that the Diamondhead partnerships have viable claims under Arkansas’ fraudulent transfer statute, including conspiracy to defraud and misrepresentation regarding the use of their investments. The statute states that a transfer is fraudulent if made without receiving "reasonably equivalent value" and if the debtor foresaw incurring debts beyond their repayment capacity. If Cagan's interpretation is accurate, the sale of Diamondhead likely meets these criteria, as Equity incurred significant debt while receiving less value in return. Therefore, as the receiver for both the partnerships and Equity, Cagan is positioned to assert claims that the Equity-Southmark transaction is voidable under fraudulent transfer laws.
However, to prevent Southmark from foreclosing on Diamondhead, Cagan must demonstrate that Southmark acted in bad faith, as Arkansas law distinguishes between good and bad faith parties in fraudulent transfers. The court has not yet addressed the parties' arguments regarding this aspect, and it remains unclear what relief Cagan may achieve on remand.
The district court's decision to grant summary judgment was flawed due to its assumption regarding a disputed factual issue. The court concluded that Equity benefitted from the alleged Diamondhead scheme, but evidence, particularly Gordon's affidavit, contradicts this by indicating that Southmark conspired with Equity's officers to inflate property prices, ultimately leaving Equity impoverished. This conduct is characterized as "looting," which implies that Equity suffered injury, thereby allowing its receiver to sue Southmark for recovery of misappropriated funds, supported by precedent in Schacht v. Brown. The case parallels Schacht, where a liquidator was granted standing to pursue claims despite arguments that the corporation had benefited from the directors' misconduct. Consequently, Cagan has the right to invoke Arkansas' fraudulent transfer statute to delay Southmark's foreclosure until Equity and the Diamondhead partners can present their claims in court. The court has ordered the case reassignment to Judge Grady and consolidation with a related case, prohibiting Southmark from obtaining relief until the merits of both cases are resolved. The judgment has been reversed and remanded.
Partners allege that Equity was aware of fraudulent promises made by its officers, which does not contradict Equity's assertion that it was victimized by its directors' collusion with Southmark. Section 4-59-204 outlines that a debtor's transfer or obligation is considered fraudulent to a creditor if it occurs without receiving equivalent value, particularly if the debtor is engaged in a transaction with insufficient remaining assets or intends to incur debts beyond their repayment capacity. Gordon's affidavit indicates that when Equity purchased Diamondhead, he recognized that the incurred debt exceeded Equity’s ability to pay it when due and acknowledged the need to establish new partnerships to fulfill these obligations, noting that mortgage payments outstripped the capacity to sell lots during the initial ownership period.
