Stone v. Citizens Equity First Credit Union (In re Int'l Supply Co.)

1

In re INTERNATIONAL SUPPLY CO., Debtor,

SHELDON STONE, not individually but solely as trustee of the International Supply Co. Creditor Trust, Plaintiff-Appellee, v. CITIZENS EQUITY FIRST CREDIT UNION, Defendant-Appellant.

No. 22-cv-3066

United States District Court, C.D. Illinois, Springfield Division

September 11, 2023

Appeal from: Adversary Case No. 17-08049 Bankruptcy Case No 15-81467 Honorable Mary P. Gorman, presiding

OPINION

COLLEEN R. LAWLESS, UNITED STATES DISTRICT JUDGE

Defendant-Appellant Citizens Equity First Credit Union ("CEFCU") appeals the order of the Bankruptcy Court finding two payments made to CEFCU by Plaintiff Appellee International Supply Co. ("ISCO") on August 2,2013, and August 16,2013, were fraudulent and subject to avoidance under 740 ILCS 160/5(a)(2) and 740 ILCS 160/6. Specifically, CEFCU contests the Bankruptcy Court's use of multiple tests to determine insolvency and constructive fraud and insists that only one test is permissible. Because both 740 ILCS 160/5(a)(2) and 740 ILCS 160/6 permit the use of multiple tests, the Bankruptcy Court properly ruled in favor of ISCO. The decision of the Bankruptcy Court is AFFIRMED.

I. BACKGROUND^[1]

On September 24, 2015, ISCO filed its voluntary petition under Chapter 11 of the Bankruptcy Code and, shortly thereafter, sought permission to sell substantially all its assets. (A432). ISCO's creditors then established a creditor trust and Sheldon Stone was appointed as the Trustee of the creditor trust. (Id.). He was vested with the authority to pursue causes of action for the benefit of the creditors, including actions to avoid and recover fraudulent conveyances under the Bankruptcy Code and applicable law. (Id.).

On September 22, 2017, ISCO filed a 10-count complaint against CEFCU and sought to avoid transfers of money from ISCO to CEFCU pursuant to the Bankruptcy Code and the Illinois Uniform Fraudulent Transfer Act ("IUFTA"). (A19). ISCO alleged that the transfers made to CEFCU in August 2013 were made for the benefit of Lee Hofmann, who owed money to CEFCU, and that ISCO did not receive reasonably equivalent value in exchange for the transfers. (A25; A434). The trial focused on the nature of the transfers from ISCO to CEFCU in August 2013. (A24; A437). The disputed issues were (1) whether ISCO was insolvent when the transfers were made or became insolvent by reason of the transfers, and (2) whether ISCO received reasonable equivalent value for all or some portion of the transfers it made. (A437).

At trial, Bradley Sargent, a certified public accountant, testified for ISCO and prepared a report analyzing whether ISCO was insolvent. (A437; A559-60). He opined on the issue of ISCO's solvency based on the three tests prescribed by 11 U.S.C. § 548-the balance sheet test, the cash flow test, and the adequate capital test. (A439; A568). Under the balance sheet test, he concluded ISCO had positive equity from 2011 to 2013, but negative equity in 2014. (A446; A630). This means that the ISCO passed the balance sheet test for 2011,2012, and 2013, but failed the test for 2014. (A446; A630). Sargant explained that the balance sheet test demonstrated positive earnings and earning capacity but was flawed in that it did not contemplate the shareholder advances that correlated with ISCO's increasing liabilities. (A446; A630-32). Under the cash flow test, which demonstrates ISCO's ability to pay its debts as they become due, Sargent determined ISCO failed the test in each of the four years observed. (A446-48; A669; A642). Under the adequate capital test, which demonstrates whether an organization has adequate capital to support its expenses and obligations, Sargent also concluded that ISCO was insolvent at all relevant times. (A449-50; A655).

CEFCU called Neil Gerber, another certified public accountant, as its expert witness. (A451; A708). Mr. Gerber prepared a report regarding the issue of ISCO's insolvency using all three tests. (A710-11). Like Sargent, he concluded that ISCO passed the balance sheet test from 2011, 2012, and 2013. (A452; A739-40). Defense counsel then asked Gerber during direct examination about the cash flow test. (A791). Regarding the cash flow test, Gerber opined ISCO would be considered solvent if refinanced debt was considered as a cash source but admitted that, if excluded, ISCO would be considered insolvent under the test. (A455; A777-78; A803; A833). He also concluded that ISCO would pass the adequate capital test because of its cashflow and the added intangible value of ISCO's good will. (A455-56; A781). The "good will" included its reputation, products, customers, workforce, technologies, and other qualitative factors. (A779-80).

When Sargent was recalled as a witness, he explained that Gerber's reasoning regarding the cash flow test was not accurate because it did not consider the fact that ISCO's refinanced debt did not create cash flow. Instead, it only extended the maturity date on the debt. (A460; A893).

During its closing argument, counsel for CEFCU argued: "I think it's clear to the Court that the most critical portion of this case revolves around the cash flow test, with respect to solvency." (A914). CEFCU then focused its arguments on explaining why Gerber's analysis regarding the inclusion of refinanced debt in the cash flow analysis was proper. (A914-16).

The court agreed with Sargent's analysis and ruled that based on all three insolvency tests, ISCO was insolvent before, at the time of, and after the CEFCU transfers were made in August 2013. (A466-78). The Bankruptcy Court explained that the three tests are "regularly relied on by courts deciding issues of insolvency under both the [Bankruptcy] Code and the IUFTA." (A467). The court also found that ISCO did not receive reasonably equivalent value for either transfer. (A478-88). As such, the court concluded both transfers were constructively fraudulent and avoidable. (A489-96).

CEFCU timely filed a Notice of Appeal from that order on April 26, 2022. (A920-22). On May 4,2022, the Bankruptcy Court issued an order awarding certain taxable costs against CEFCU. (A925-28). CEFCU timely filed a Notice of Appeal from that order on May 16, 2022. (A933-48). CEFCU argues on appeal that the Bankruptcy Court erred in finding ISCO was insolvent and that the 2013 payments were fraudulent. Specifically, CEFCU contends that the cash flow and adequate capital tests are extra-statutory and were improperly utilized by the Bankruptcy Court.

II. ANALYSIS

A. Standard of Review

The Court has appellate jurisdiction over this matter. See 28 U.S.C. 158(a)(1) (providing that district courts have jurisdiction to hear an appeal from a final judgment, order, or decree). a The Court reviews the Bankruptcy Court's factual findings for clear error. Ojeda v. Goldberg, 599 F.3d 712, 716 (7th Cir. 2010). Whether an entity is insolvent is a question of fact. Plankinton Bldg. Co. v. Grossman, 148 F.2d 119, 125 (7th Cir. 1945). Whether the Bankruptcy court employed the correct legal standard is subject to de novo review. Lewis v. Citgo Petroleum Corp., 561 F.3d 698, 705 (7th Cir. 2009).

B. Count I

At the core of this case is whether constructive fraud and insolvency may only be proven by the balancing sheet test, or whether other measures may be introduced to demonstrate constructive fraud and insolvency. 11 U.S.C. § 544(b) allows a trustee to bring a state law cause of action in the context of a bankruptcy proceeding. Here, the bankruptcy proceeding was brought under two state laws: 740 ILCS 160/5 and 740 ILCS 160/6. (All-17). Because both statutes -740 ILCS 160/5 and 740 ILCS 160/6-contain different elements, this Court will first assess whether the use of the cash flow and adequate capital tests was proper under Section 106/5. Second, this Court will analyze whether the use of the other tests was proper under Section 106/6.

To demonstrate constructive fraud under Section 160/5(a)(2) of the IUFTA, the debtor must have made the transfer without receiving a reasonably equivalent value in exchange, and either: (1) the debtor's remaining assets were unreasonably small in relation to the business or transaction, or (2) the debtor intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due. 740 ILCS 106/5(a)(2).

"Unreasonably small assets" is not defined in the IUFTA. See In re Doctors Hosp, of Hyde Park, Inc., 507 B.R. 558, 635 (Bankr. N.D.Ill. 2013). But courts have recognized that "unreasonably small capital involves financial circumstances in which the debtor is left barely solvent and in a condition where bankruptcy or liquidation is substantially likely" and "an inability to generate sufficient profits to sustain operations." In re Doctors Hosp, of Hyde Park, Inc., 507 B.R. at 635. This is akin to the adequate capital test described by both experts. In his report, Sargent described the adequate capital test as determining "if the debtor has the available capital to operate the business for a specific period, typically one year." (A315). Gerber's definition was similar, defining the test as determining "whether the debtor has adequate capital relative to its assets, and able to meet its expenses and debt obligations as they become due, typically within one year." (A404). Since the adequate capital test measures unreasonably small assets, it is an appropriate test under the IUFTA.

Section 5(a)(2) of the IUFTA also provides that a transfer is fraudulent if the debtor has incurred debts beyond his ability to pay as they become due. 740 ILCS 106/5(a)(2)(B). Sargent described the cash flow test as determining "if the debtor has cash available to meet all debt obligations for the period." (A314). Gerber's definition was...