Trustee Of Securitized Investment Pool Is An "Initial Transferee" Under The Code
PALOIAN v. LASALLE BANK (August 27, 2010)
James Desnick purchased the Doctors Hospital of Hyde Park in 1992, after he left the practice of medicine amid charges of misconduct. The Hospital remained open until 2000. Two loans are at issue in this appeal. In March of 1997, MMA Funding (also owned by Desnick) obtained a $25 million line of credit from Daiwa, which it then made available to the Hospital. In return, the Hospital transferred its accounts receivable to MMA, and MMA gave Daiwa a security interest in them. In August of the same year, Nomura Asset Capital Corporation loaned $50 million to HPCH (which owned the building and land -- and was also owned by Desnick). HPCH made the $50 million available to the Hospital. In return, the Hospital paid additional rent to HPCH and HPCH gave Nomura a security interest in the rent. The Nomura loan was later securitized, sold to a third party, and transferred to a trust. LaSalle National Bank is the trustee. Cash-flow problems led to the Hospital's bankruptcy filing. The trustee in bankruptcy sought to recover some of the payments on the loans as fraudulent conveyances. The bankruptcy court concluded that the Hospital was insolvent at least by August of 1997, that the increased rent was in reality debt service, and that the Nomura loan repayments were fraudulent conveyances. The bankruptcy court also concluded that repayments on both loans after July of 1998 were outside the bankruptcy because they were made with MMA's assets, not the Hospital's. Judge Pallmeyer (N.D. Ill.) affirmed the bankruptcy court. Both trustees appeal.
In their opinion, Chief Judge Easterbrook and Judges Rovner and Tinder vacated and remanded. The Court first addressed LaSalle's argument that it is not an "initial transferee" under the Code and that the payments cannot therefore be recovered. Although the Code does not define "initial transferee," the Court relied on its own earlier decision in Bonded Financial Services to conclude that LaSalle was the real recipient of the transfer since it was the legal owner of the trust's assets. Next, the Court addressed whether the Hospital was insolvent in August of 1977. The trustee in bankruptcy cannot avoid the transfers unless it was. The bankruptcy court used a discounted-cash-flow analysis (which showed that the Hospital was comfortably solvent), but then subtracted $18.5 million that a later audit determined to be the amount of Medicare overpayments, and then reduced its future income calculation by 40% because it was a Subchapter S corporation. The court reasoned that a tax-paying buyer would reduce the purchase price because of tax consequences. The Court found both downward adjustments to be in error. With respect to the Medicare overpayments, the Court stated that the balance sheet should have included an estimate (as of 1997) of the Hospital's liability on the Medicare audit and an estimate of how much Desnick would contribute. Here, Desnick paid the entire $18.5 million. Since the court used hindsight to include the $18.5 million of liability, it should have used the same hindsight to eliminate the liability because of Desnick's contribution. With respect to the 40% reduction, the Court concluded that the discount could only be justified by the illiquidity of the Hospital's shares or the potential that a tax-paying entity bought the hospital. But neither of those is relevant to the Hospital's solvency. The Court therefore concluded that the Hospital was solvent in August of 1997 and that the following months’ debt service was not a fraudulent conveyance. The Court noted that, on remand, the bankruptcy court may be asked to determine whether the Hospital was insolvent at some other time after August of 1997 but before it filed for bankruptcy. Finally, the Court addressed whether Desnick and Daiwa succeeded in creating a "bankruptcy-remote vehicle" in MMA. If they did, Daiwa could rely on the assets of MMA without fear of bankruptcy implications if the Hospital failed. Such an arrangement requires that the separate entity (here, MMA) be independent and separate and observe corporate formalities. The Court noted that those attributes appear to be missing here. MMA was not independent, it was not separate, it had little existence outside the loan documents, and did not even actually purchase the accounts receivable. The Court did allow for the possibility that a record could be developed otherwise on remand -- if, in fact, the bankruptcy court determines that the Hospital was insolvent at some time before filing.
Michael Rigney practices in the law offices of GVC Ltd. in Chicago. In this blog, he reports on select