Stone v. Citizens Equity First Credit Union

The trustee for the International Supply Co. (ISCO) asked the bankruptcy court to avoid and recover prepetition fraudulent transfers made to Citizens Equity First Credit Union (CEFCU). The bankruptcy court determined that ISCO was insolvent when the transfers were made, not to satisfy its debts but rather for the benefit of the controlling shareholder, and the transfers were avoided. Judgment was made in favor of the trustee. 

Facts.

ISCO filed its voluntary petition under Chapter 11 on September 24, 2015. ISCO was permitted to sell all of its assets substantially, generating more than $10 million gross for the bankruptcy estate. The creditors’ committee filed a plan of liquidation, affirmed by the trust. Sheldon Stone, the trustee, commenced this proceeding against CEFCU, E. Lee Hoffman (Lee), and Rebecca Hoffman (Rebecca), seeking to avoid money transfers from ISCO to CEFCU and Rebecca made on behalf of Lee. The complaint sought relief under the Bankruptcy Code and the Illinois Fraudulent Transfer Act (IUFTA) or, in the alternative, judgment against the defendants for unjust enrichment and breach of fiduciary duties to ISCO. 

The trustee’s motion to remove Rebecca was granted, and the trial proceeded with CEFCU as the sole defendant in late 2021. 

Lee founded ISCO in 1983, at all times subsequent with Rebecca and Lee as employees and controlling shareholders. Rebecca also managed Games Management LLC (Games). In September 2004, Games executed a note in favor of CEFCU for $2.7 million. Lee guaranteed the note. Games ultimately defaulted on the note. On January 19, 2011, CEFCU obtained a judgment against Lee for $2.8 million. On March 18, 2011, another judgment was entered in favor of CEFCU against Lee for approximately $254,000.

CEFCU obtained liens against Hoffman, including against his ISCO salary. Lee’s salary was diverted to Rebecca. CEFCU obtained a judgment against Rebecca and ISCO jointly and severally for $262,000. All parties entered into a global settlement agreement whereby Lee agreed to pay CEFCU $2.01 million by August 1, 2013. The deal was further amended, and ISCO tendered $1.4 million on August 2, 2013, and another $320,000 on August 16, 2013.

ISCO signed a promissory note for $3.75 million to Heartland Bank on October 1, 2014. ISCO filed for bankruptcy on September 24, 2015.

Evidence at trial.

The issues at trial were whether ISCO was insolvent at the time of the transfers or became insolvent due to the transfers and whether ISCO received reasonably equivalent value for all or some transfers.

Bradley Sargent, CPA, CFE, testified on behalf of the trustee as an insolvency expert. In his report, he opined that ISCO received no equivalent value for the $1.72 million in transfers, and ISCO was insolvent before and after the transfers occurred. Sargent reviewed the financial data and FASB standards that he used to come to his opinions, relying heavily on year-end reviewed financial statements of ISCO. He also reviewed ISCO’s accounting and bank records and various depositions of persons who would be knowledgeable on the equivalent value issue.

Per Sargent, there was a strong correlation between the advances made to Lee and the liquidation of cash reserves of ISCO. Sargent called the advances a “fatal disease” for ISCO. The IRS recharacterized some of the advances as income to Lee. The Heartland Bank credit analyses were also helpful in determining insolvency by Sargent.

Sargent assessed each of the three insolvency tests. As for the balance sheet test, Sargent determined the fair value of the assets by applying the comparable transaction market approach method and the income approach to determine the invested capital and enterprise values. He added back the non-interest-bearing liabilities to determine the fair value of ISCO’s assets. He offset the total asset values by the total liabilities to determine that, in 2014, ISCO had negative equity but a positive equity value from 2011 to 2013.

As for the cash-flow test, Sargent analyzed ISCO’s cash flows on a 12-month basis since that was when ISCO’s debts were due. He determined that 99% of ISCO’s debts were due within one year, indicating that lenders were not lending to ISCO for the long term. Additional financing was not included as a source of cash as it only acted to extend due dates on existing debt. Sargent determined the annual cash-flow deficit for each of the four years measured was more than $3 million.

As to the good capital test, Sargent did not do a complete analysis since the failure of the cash-flow test defaults to a loss of the adequate capital test.

CEFCU called Neil Gerber, CPA/ABV, CFE. Gerber was familiar with Sargent’s report and used many of the same documents in his analysis. Due to his lack of publishing experience and experience in insolvency, the trustee objected to his testifying. The court allowed the testimony, noting that “[t]he objection was overruled with this Court finding that the insolvency tests at issue involved common accounting principles about which Mr. Gerber was well qualified to testify.”

Gerber utilized only the comparable transactions method of the market approach and did not utilize an income approach saying his calculations would have been the same. He used an EBITDA multiple of 5.0, added back available cash, and deducted ISCO’s actual and contingent liabilities. “He estimated ISCO’s contingent liabilities, which related to corporate guarantees of Mr. Hofmann’s debts, using a weighted-average-probability method.” His result was net equity of over $8 million for the periods analyzed. However, he utilized the periods from July 2013 and August 2013 using in-house interim financials. He checked the interim information against year-end reviewed data, did not find any inconsistencies, and determined that ISCO passed the balance sheet test at all relevant times.

Gerber’s cash-flow analysis also showed positive cash flows for the July 2013 and August 2013 periods. However, he included debt refinancing as a source of cash. “Between the end of 2013 and 2014, shareholder advances nearly doubled, and EBITDA dropped, eroding the debt service coverage ratio. It was not until that point, Mr. Gerber concluded, that ISCO was really in trouble.” He opined that ISCO was solvent both before and after the transfers.

As to the adequate capital test, Gerber used goodwill as a part of the capital and determined that, since ISCO passed the cash-flow test, it also had goodwill from its technology, etc. Thus the capital of ISCO was adequate with goodwill. Gerber did not feel that the crippling advances to Lee did not become a problem until 2014, and thus ISCO was solvent when the transfers to CEFCU were made in 2013.

On cross-examination, Gerber admitted to including payments from the Microsoft contract and determined an EBITDA of $4.875 million for both months, even though ISCO had never reached an annual EBITDA of $4.0 million. Gerber admitted ISCO was unable to pay its debts without refinancing. Gerber remained firm that ISCO was solvent when the transfers were made.

The trustee then called Sargent as a rebuttal witness to Gerber. He disagreed with Gerber’s opinions and called them misleading for several reasons. For example, “simply subtracting the $1 million loan request to cover input costs from the $2.44 million contract price to create an additional $1.375 million in projected sales growth was not mathematically correct.”

At this point, the bankruptcy court analyzed both the jurisdiction and legal analysis of the issues in this case. “What remains in dispute is whether ISCO was insolvent when the transfers were made or became insolvent as a result of the transfers and whether CEFCU provided reasonably equivalent value for the first two transfers it received in August 2013.”

ISCO was insolvent when it transferred funds to CEFCU.

The Bankruptcy Code and the IUFTA have essentially the same definition of insolvency. The IUFTA also provides that a “debtor who is generally not paying his debts as they become due is presumed to be insolvent.” The bankruptcy court found the analysis of the three tests helpful in making its decision. Both experts were qualified, testified professionally, and were helpful to the bankruptcy court. Both agreed the operations of ISCO were profitable but that solvency had to consider the depletion of cash reserves and cash generated by operations being diverted to Lee. In considerable measure, the experts parted in the manner of weight to be given to diverting cash from ISCO to Lee. Sargent placed significant weight on the diversions, while Gerber placed more on the positive outcomes of ISCO’s manufacturing operations. The bankruptcy court found Sargent’s approach more persuasive.

The balance sheet test.

Both experts agreed that the balance sheet test was passed for the relevant periods.

The cash-flow test.

Sargent determined that the cash-flow test showed that ISCO was insolvent from 2011 to 2014. Gerber performed the cash-flow test for the limited periods of July 2013 and August 2013 and opined that ISCO was solvent at the end of each month. To some degree, Gerber was double counting the revenues from the Microsoft contract. In rebuttal, Sargent noted that the end-of-year EBITDA showed that the two-month EBITDA, as determined by Gerber, did not pass the sanity check. Thus, Gerber’s entire adjustment should be disregarded.

Sargent also said that the entire $3.6 million of refinancing should be disregarded as it is not a cash infusion but cash to pay off debts. The bankruptcy court agreed with Sargent on this. “Based on Mr. Sargent’s cash flow analysis, which the Court found credible, and on Mr. Gerber’s cash flow analysis, as altered by the rejection of the two adjustments, it is clear that ISCO was insolvent both before and after making the transfers at issue to CEFCU.”

The adequate capital test.

Sargent determined ISCO failed this test in part because it failed the cash-flow test. Gerber’s cash-flow test had errors, and Gerber used it to determine adequate capital. Gerber’s balance sheet included goodwill as an asset, not on the balance sheet but helping to indicate adequate capital. Based on all three tests, the bankruptcy court determined that ISCO was insolvent before, during, and after the transfers to CEFCU.

ISCO received less than reasonably equivalent value in exchange.

The trustee bears the burden of proving that ISCO received less than the equivalent value in exchange for the transfers to CEFCU. Once that burden is met, it shifts to CEFCU to prove otherwise. The determination of equal value requires a three-part inquiry by the court: (1) a determination by the court that a debtor received some value; (2) the value must be in exchange for the transfers; and (3) the value received must have some reasonable equivalence to the value of the transfers.

The trustee met his burden on value.

The trustee offered evidence that the ISCO/Rebecca judgment was not satisfied until CEFCU received the final $300,000 payment from Morton Community Bank. That judgment included the $1.72 million payments ISCO made to CEFCU. Thus, the burden shifted to CEFCU to show what ISCO received in exchange.

CEFCU failed to show ISCO received value for the transfers.

In addition to the release of the Rebecca note of $261,800, CEFCU contended that ISCO benefited from releasing the trust property worth $900,000 or more. Both contentions were untenable. CEFCU also argued that it released claims for attorneys’ fees, post-judgment interest, and costs. The record did not support such a finding.

Release of the Hofmann irrevocable trust property.

ISCO never owned title to the trust property. “As far as the Court can tell, every action taken by ISCO for Mr. Hofmann’s benefit did more harm than good to ISCO.” CEFCU’s release of the trust property was not the value ISCO received. “Thus, the Court concludes that ISCO did not receive any value in exchange for the August 2013 transfers to CEFCU totaling $1.72 million.” The transfers of $1.72 million and $320,000 were avoided and must be repaid by CEFCU to ISCO.