Fraudulent Conveyance and Piercing the Veil

Fraudulent Conveyance and Piercing the Veil

 

In a recent decision, the Federal District Court found (a) that certain mortgages and security interests were fraudulent conveyances and (b) that the veils of a variety of entities should be pierced in order to hold the control person liable for an arbitration award against two of those companies.  Kentucky Petroleum Operating Ltd. v. Golden, Civ. No. 12-164-ART, 2015 WL 927358 (E.D. Ky. March 4, 2015).

 

      Two LLCs, 7921 Energy LLC and Macar Investments, LLC (collectively the “Macar parties”) sold gas and oil well properties and equipment to Kentucky Petroleum Operating, LLC and Kentucky Petroleum Operating, Ltd.  (collectively the “KPO debtors”).  Disputes arose over performance under those agreements, and that dispute went to arbitration.  Between the arbitration hearing and the rendering of the decision, the KPO debtors, working in concert with affiliated companies, mortgaged/pledged their assets to those same affiliated companies, particularly Kentucky Petroleum Limited Partnership (“KPLP”).  The mortgage allowed KPLP to foreclose on the leases in the event of a transfer by operation of law, described by Judge Thapar as:

Taking a page out of playground negotiation, KPLP essentially called “dibs” in the event they ever left the KPO debtors’ possession.

      The Macar parties prevailed in arbitration, and were awarded against the KPO debtors a judgment of $466,187.  With the assets of the KPO debtors fully encumbered, the Macar parties (i) argued that the mortgages/pledges between the KPO debtors and the related companies were fraudulently transferred and (ii) the KPO debtors, KPLP and other entities are actually alter-egos of one another and their veils should be pierced to reach Mehran Ehsan, their common controller.

Fraudulent Conveyance

      Kentucky law voids any conveyance of property made with the intent to “delay, hinder, or defraud creditors,” KRS § 378.010; subsequent creditors are likewise protected.  Myers Dry Goods, Inc. v. Webb, 181 S.W.2d 56, 59 (Ky. 1944).  There was in this case no dispute that one “badge of fraud” existed, namely that the mortgages/pledges were given during the pendency of a lawsuit.  2015 WL 927358, *4.  With that badge of fraud the burden shifted to the KPO debtors to show that the mortgages/pledges were given in good faith.  This they failed to do.  In response to the position that the KPO debtors did not think the Macar parties to be creditors at the time of the mortgages/pledges, the Court found that their subjective view is largely irrelevant.  Rather:

Even if the KPO debtors did not consider the Macar parties their “creditors” when they recorded the UCC–1 and mortgage, the law did: “A person who has a claim for damages against a grantor is a creditor within the meaning of [the fraudulent conveyance statute].” Lewis, 49 S.W. at 329; Hager, 208 S.W.2d at 519–20 (finding a debtor-creditor relationship where the debtor had “reason to believe and anticipate” that the creditor would take action against him). Moreover, section 378.010 protects both then-existing and subsequent creditors from a debtor’s fraudulent conveyances. Myers, 181 S.W.2d at 59. Thus, section 378.010 applies even if the KPO debtors did not believe the Macar parties were creditors at the time they executed the mortgage and UCC–1. Id.

The Court rejected the assertion that good faith is a fact question requiring a jury trial on the basis that they failed, in the face of an admitted badge of fraud, to “present any evidence disputing that they harbored intent to defraud.” Id.  There was also rejected (on grounds that are not entirely clear) the claim that the mortgages/pledges were given in satisfaction of an existing indebtedness. Id. at *6.

The Macar parties were granted summary judgment on their claims for fraudulent conveyances.

Piercing the Veil

      The decision recites the piercing test adopted by the Kentucky Supreme Court in Inter-Tel Technologies, Inc. v. Linn Station Properties, LLC, 360 S.W.3d 152, 165 (Ky. 2012), noting that:

In Kentucky, alter ego liability boils down to “two dispositive elements: (1) domination of the corporation resulting in a loss of corporate separateness and (2) circumstances under which continued recognition of the corporation would sanction fraud or promote injustice.”

      As for the lack of separateness, it was found that the KPO debtors and the related companies share common leadership in Mehram Ehsan, there was inadequate capitalization of at least one of them, formalities were ignored and the entities comingled their funds.  Id. at *7.

      The fact that Mehram Ehsan was not named as a party in the suit, that raised as a bar to the Court piercing the veil, was described as “mistaken.”

      Having found a lack of separateness, the Court turned its attention to the second prong of the piercing analysis, namely whether or not piercing would sanction fraud or promote injustice.

      While acknowledging that the injustice needs to be more than the creditor is not paid, the Court determined:

[O]ne such injustice is a parent corporation or director causing a subsidiary’s liability and then rendering the subsidiary unable to pay that liability. Ehsan, who controls and directs all of the KPO entities, incurred liability on behalf of the KPO debtors by executing both the Macar and 7921 PSAs on behalf of the KPO debtors. An arbitrator found that the KPO debtors breached the PSAs and awarded damages to the Macar parties. Ehsan then rendered the KPO debtors unable to meet their PSA obligations. As the Court explained in section II, the KPO entities—at the direction of Ehsan—stripped assets from the KPO debtors, meaning that the Macar parties could not collect their arbitration award. Accordingly, continued recognition of the separate corporate forms of the various KPO entities would sanction an injustice.

A second injustice is a scheme to shift assets to a liability-free corporation while shifting liabilities to an asset-free corporation.  In this case, all of the liabilities fell on the KPO debtors because they are the only parties named in the arbitration award. Meanwhile, non-debtor KPLP took all of KPO, LLC’s assets and all of the KPO debtors’ revenue under the PSAs. On these facts, the continued recognition of the KPO entities’ supposedly “separate” corporate forms would sanction injustice. Because the Court finds that the KPO entities lack corporate separateness and that recognizing separate corporate forms would sanction an injustice, the Court will pierce the corporate veil and treat the KPO entities as a single entity. Id. at *8 (citations omitted).

From there the conclusion was a foregone, namely:

Because the Court finds that the KPO entities lack corporate separateness and that recognizing separate corporate forms would sanction an injustice, the Court will pierce the corporate veil and treat the KPO entities as a single entity. Id.