Court: United States Bankruptcy Court, W.D. New York; February 7, 2017; Us Bankruptcy; United States Bankruptcy Court
The Chapter 11 Trustee filed a lawsuit against several commercial lenders, collectively referred to as "banks," concerning loans made to Cornerstone Homes, Inc. The Trustee's complaints allege that the banks' cash infusions facilitated a Ponzi scheme orchestrated by David Fleet, Cornerstone's former principal, which defrauded numerous private investors. The banks moved to dismiss allegations of actual and constructive fraud under New York Debtor Creditor Law (NYDCL), citing various legal grounds including failure to state a claim, lack of standing due to the in pari delicto doctrine, and statute of limitations issues. The Court, applying the pleading standards from Iqbal and Twombly, concluded that the Trustee sufficiently pled the fraud claims, allowing them to survive the motions to dismiss. The Court also determined that the in pari delicto defense did not eliminate the Trustee's standing for avoidance actions under 11 U.S.C. § 544(b). Additionally, the Court found that factual questions surrounding the discovery of fraud made the statute of limitations defense premature. Consequently, both CPC's and First Citizens' motions to dismiss were denied.
Jurisdiction is established under 28 U.S.C. §§ 157(a), 157(b)(1), and 1334, with the case classified as a core proceeding under 28 U.S.C. § 157(b)(2)(H). Cornerstone, founded in 1999 by Fleet, operated under a business model that involved purchasing and rehabilitating single-family homes in Southern New York, selling them to high-risk, low-income borrowers who typically could not secure conventional mortgages. Initially aimed at aiding disadvantaged individuals, the Trustee alleges that Cornerstone devolved into a Ponzi scheme orchestrated by Fleet. The model was flawed as its borrowers were often unable to repay their loans, leading to insufficient cash flow to meet obligations to private investors.
To maintain operations, Fleet sought additional funds by promoting Cornerstone's financial health to both current and potential investors, promising attractive returns and emphasizing a lack of bank financing. By 2005, Cornerstone had borrowed over $12.7 million from private investors. Despite initial provisions for investors to secure collateral in the form of Cornerstone real estate, the company’s cash flow fell short of fulfilling Fleet's promises. After 2006, Fleet began borrowing from commercial lenders, including CPC, while still asserting to investors that Cornerstone relied solely on private funding, despite being insolvent.
From 2006 to 2009, CPC entered into five loan agreements with Cornerstone, totaling over $12.7 million, primarily aimed at refinancing debts owed to private investors. The CPC# 1 and CPC# 2 Loans required private investors to assign their Cornerstone notes and mortgages to CPC, with some loan proceeds designated to settle amounts owed to those investors. However, the approach to managing these transactions altered over time.
CPC did not mandate the assignment of private investors' mortgages for the CPC# 3 Loan, with the majority of proceeds going directly to Cornerstone rather than the investors. For the CPC# 4 and CPC# 5 Loans, none of the proceeds were allocated to private investors. As part of its due diligence, CPC requested audited financial statements and tax returns from Cornerstone, revealing net losses and indicating insolvency from 2003 to 2005. Although Cornerstone's tax returns from 2006 to 2009 indicated insolvency, its financial statements claimed solvency, citing unreceived amounts as income.
From 2006 to 2009, First Citizens lent Cornerstone over $7.1 million through five loan transactions intended to refinance Cornerstone's debts to private investors. For the FC# 1 and FC# 2 Loans, First Citizens required the transfer of 83 parcels of real property to a newly formed entity, CNY Homes, to protect against claims from Cornerstone's creditors. These loans involved private investors assigning their Cornerstone notes and mortgages to First Citizens, with some proceeds allocated for payments to those investors. The FC# 3 Loan served as a revolving credit facility, while the FC# 4 and FC# 5 Loans aimed to restructure Cornerstone's debt without requiring mortgage assignments or designating proceeds for private investors. First Citizens, like CPC, conducted due diligence, obtaining financial records that showed mixed indications of Cornerstone's financial health. By 2005, Cornerstone had over $11 million in secured private investor loans, but by 2006, it began soliciting unsecured loans, totaling over $15 million from private individuals by 2010.
The Trustee asserts that financing from CPC and First Citizens allowed Debtor, Fleet, to repay private investors, creating a misleading impression of a legitimate business operation. This façade helped Fleet solicit additional unsecured loans, further facilitating the continuation of its Ponzi scheme. As the scheme began to collapse in 2010, Fleet used unencumbered real property to negotiate forbearance agreements with CPC and First Citizens, including accepting millions of dollars in collateral from Cornerstone. Despite this, Fleet continued payments to the banks to avoid personal liability, diminishing funds that could have been used to pay unsecured private investors.
The Trustee argues that CPC and First Citizens were aware, or should have been aware, of Cornerstone's insolvency and its reliance on private investor loans to meet financial obligations. The banks allegedly recognized the risks associated with high-risk property purchasers and the unsustainable nature of the Ponzi scheme. Consequently, the Trustee accuses the banks of actual and constructive fraud, seeking to void obligations and transfers made to them.
The central legal question is whether the Trustee has adequately pled claims of actual and constructive fraud to withstand the banks' motions to dismiss. The Court finds that the Trustee has met the necessary pleading standards under Rules 12(b)(6), 9(b), and 8(a) of the Federal Rules of Civil Procedure. It emphasizes that, when evaluating motions to dismiss, the Court must accept the complaint's factual allegations as true and draw reasonable inferences in favor of the plaintiff, focusing on whether the claimed facts, if true, could plausibly support a legal claim.
The court is limited to considering only the allegations within the complaint and its attachments. The Trustee's complaints against CPC and First Citizens assert actual fraud claims under NYDCL §§ 276 and 276-a, seeking to void transfers linked to specific loans. NYDCL § 276 states that any transfer made with actual intent to obstruct creditors is considered fraudulent. Under Rule 9(b) FRCP and Rule 7009 FRBP, fraud claims require detailed pleading, specifying the property conveyed, the timing and frequency of transfers, and the consideration exchanged. This heightened standard aims to clarify the alleged fraudulent actions, protect defendants from unfounded claims, and minimize frivolous lawsuits. While plaintiffs must detail the circumstances of fraud, intent can be alleged more generally. A strong inference of fraudulent intent can be demonstrated by showing motive and opportunity or strong circumstantial evidence of misconduct. The Trustee may utilize various "badges of fraud" to establish intent, including relationships among parties, suspicious transfer patterns, significant discrepancies in value, and the financial condition of the debtor at the time of transfer. Courts in the Second Circuit are divided on whether only the transferor's intent needs to be alleged, or if the transferee's intent must also be included, with some cases assuming the necessity of alleging both.
CPC seeks dismissal of the Trustee's claims of actual fraud under Rule 12(b)(6) and Rule 9(b) of the Federal Rules of Civil Procedure, arguing the Complaint contains conclusory allegations lacking factual support. CPC challenges specific allegations by providing alternative facts and additional information not included in the Complaint, such as the terms of its loans to Cornerstone and its due diligence process. CPC contends that its loans, which featured lower interest rates and longer amortization periods, enabled Cornerstone to settle debts with individual investors. Additionally, CPC claims it lacked knowledge of any Ponzi scheme, asserting loans were made based on real estate collateral valuations.
First Citizens similarly contests the fraud claims, asserting the Complaint fails to specify the 'conveyances' and 'obligations' being avoided, lacking details on the properties, timing, and consideration of the transfers. However, the Court determines that the Trustee's allegations do present a plausible claim for actual fraud, finding sufficient specificity regarding the conveyed properties (CPC# 1-5, FC# 1-5, and Forbearance Transfers), their timing, and the consideration exchanged, thus fulfilling the heightened pleading standard of Rule 9(b). The Trustee also adequately alleges intent connected to the fraudulent conveyance claims by referencing badges of fraud and providing details on the banks' transaction patterns with Cornerstone, indicating the banks were aware of Cornerstone's insolvency at the time of the transactions.
The Trustee alleges that CPC and First Citizens knowingly provided loans to Cornerstone while aware, or should have been aware, of its insolvency, as evidenced by Cornerstone's audited financial statements and tax returns. These actions purportedly perpetuated a false perception of Cornerstone's profitability, encouraging unsecured investments and enabling a Ponzi scheme. The Court recognizes that, if true, these facts could indicate fraudulent intent through circumstantial evidence of 'conscious misbehavior or recklessness.' The Trustee also claims that Fleet, Cornerstone’s principal, utilized these loans to create the illusion of financial stability, repay individual investor loans, solicit further investments, and sustain the Ponzi scheme, continuing to incur debt while Cornerstone was insolvent. The Trustee's allegations present several "badges of fraud" concerning the timing and cumulative impact of the transactions and Cornerstone’s financial condition.
The Court concludes that the Trustee has sufficiently pleaded actual fraud claims under NYDCL § 276, negating the need to assess the consideration for CPC’s loans. Consequently, the motions to dismiss these claims by CPC and First Citizens are denied under Rules 12(b)(6) and 9(b) of the FRCP.
Regarding claims of constructive fraud (Counts VI-VIII against CPC and Counts VII-X against First Citizens), the Trustee seeks to invalidate transfers related to specific loans under applicable statutes. A divide exists in the Second Circuit regarding the pleading standard for constructive fraud claims, with the majority opinion favoring a more lenient standard, as scienter is not required. The Court adopts this majority view, applying Rule 8(a) FRCP's liberal standards to these claims. Under NYDCL, specifically § 273, any transfer made by an insolvent debtor without fair consideration is deemed fraudulent to creditors, regardless of actual intent.
Under NYDCL § 273-a, any transfer made by a defendant in a money damages action without fair consideration is deemed fraudulent to the plaintiff, regardless of the defendant's intent, if the defendant fails to satisfy a judgment after it is final. Fair consideration requires two elements: the transfer must be for fair equivalent value and received in good faith. In a motion to dismiss, the plaintiff only needs to allege a lack of fair consideration by indicating either a lack of fair equivalent value or good faith from the transferee. Some courts have stated that determining fair consideration is inappropriate at the motion to dismiss stage, as it involves complex factual analysis.
CPC and First Citizens argue for dismissal of constructive fraud claims due to insufficient facts regarding fair consideration. The court disagrees, stating that such specific evidence is not required at this early litigation stage due to the liberal pleading standards under Rule 8(a) of the FRCP. The adequacy of consideration is a factual issue and should be determined after discovery. The trustee has adequately alleged a lack of good faith on the banks’ part, asserting that they should have been aware of Cornerstone's insolvency based on its financial disclosures. Thus, the trustee’s claims meet the pleading standard necessary to counter the banks' motions to dismiss.
The Trustee alleges that CPC and First Citizens were aware or should have been aware of the unsustainable nature of Cornerstone's business model, which was functioning as a Ponzi scheme. Upon the scheme's collapse, Cornerstone's debts to CPC and First Citizens would be secured by real property, while its debts to private investors would be unsecured. These allegations are sufficient to demonstrate a lack of good faith and meet the pleading requirements for claims of constructive fraud, leading to a failure of motions to dismiss under Rule 12(b)(6) and Rule 8(a) of the FRCP.
CPC and First Citizens contest the Trustee's standing to bring claims against them based on the common law doctrine of in pari delicto, which prevents a wrongdoer from suing another wrongdoer. This doctrine is recognized in New York law and is similar to the Wagoner rule in federal courts, which denies standing to trustees in cases where the bankrupt corporation was complicit in defrauding creditors. However, neither the in pari delicto doctrine nor the Wagoner rule applies to a trustee's statutory standing under Section 544 of the Bankruptcy Code, which allows the Trustee to pursue avoidance actions without being impeded by these doctrines. Therefore, the defendants' reliance on the Wagoner rule in relation to the Trustee's fraudulent transfer claims is ineffective, as these claims are specifically conferred by the Bankruptcy Code to the trustee or debtor in possession.
The Trustee's claims to avoid fraudulent transfers in Counts I-V of the CPC complaint and Counts I-X of the First Citizens complaint are based on New York Debtor and Creditor Law (NYDCL) 276. The Trustee has standing under 11 U.S.C. 544(b) to pursue these state-law claims against creditors, with the in pari delicto doctrine and Wagoner rule not limiting this standing. CPC and First Citizens argue that the avoidance claims in Counts I and II are time-barred due to the statute of limitations, which they assert expired six years after the transactions related to the CPC and First Citizens loans. Specifically, CPC claims the statute of limitations for its loans, dated August 22, 2006, expired on August 22, 2012, while First Citizens contends that its loans, dated April 21, 2006, and November 11, 2006, expired on April 21, 2012, and November 11, 2012, respectively. Both defendants assert the bankruptcy petition filed on July 15, 2013, was outside this period, and CPC argues that the Trustee’s claims regarding the discovery rule are unfounded. Under New York law, the statute of limitations for fraud is either six years from the accrual date or two years from when the fraud was discovered or could have been discovered. The burden of proof for the statute of limitations defense lies with the defendants. The Court must accept the Trustee's allegations as true and cannot grant a motion to dismiss based on the statute of limitations when factual questions exist. The Trustee has invoked the discovery rule, alleging that the fraudulent activities were not reasonably discoverable by any unsecured creditor by the petition date. As it is not clear that a creditor had prior knowledge of the fraud, the Court cannot dismiss Counts I and II on statute of limitations grounds.
CPC and First Citizens cannot be held accountable for alleged knowledge of fraud by other creditors. Although the six-year statute of limitations on Counts I and II may have expired, the discovery rule could potentially revive these claims, necessitating a factual determination by the trier of fact. Therefore, assessing the applicability of the statute of limitations at this stage is premature. The Trustee's claims for actual and constructive fraud meet the pleading standards set by the Supreme Court in Iqbal and Twombly, as well as the heightened standards for fraud claims under Rule 9(b) of the Federal Rules of Civil Procedure, allowing them to survive a motion to dismiss under Rule 12(b)(6). Additionally, the defenses of in pari delicto and the Wagoner rule do not eliminate the Trustee's standing to pursue avoidance actions under 11 U.S.C. § 544(b). Questions of fact exist regarding when the alleged fraud was or could have been discovered, which affects the statute of limitations, making any determinations on that issue premature. Consequently, CPC's and First Citizens' motions to dismiss Counts I through VIII and I through X respectively are denied. The application of the Ponzi scheme presumption has yet to be formally addressed. The Trustee's complaints against CPC and First Citizens consist of 18 and 23 causes of action, respectively, and the first 67 paragraphs of each complaint are nearly identical. Prior rulings confirmed the enforceability and standing of the Consolidated Notes and Mortgages involved.
