The United States District Court for the Southern District of New York (the “Court”) recently affirmed Bankruptcy Judge Sean H. Lane’s decision denying a debtor’s discharge under Section 727(a)(2)(A) based on the debtor’s role as an insider of a financial consulting company established by his spouse, a nurse with no experience or training in the field of financial services. The Court affirmed several issues on appeal including the Bankruptcy Court’s determination that the debtor had a beneficial interest in his spouse’s company and that the debtor concealed his interest in the company with the specific intent of obstructing creditors. The Court provided further analysis on the application of and circumstances giving rise to the concealment doctrine.
The debtor had worked in the financial services industry for approximately forty (40) years and found himself facing financial difficulties. In the midst of his financial difficulties, the debtor’s spouse formed the corporation (“Soroban”), which primarily offered consulting services. The debtor’s spouse, who was a nurse, was listed as the owner, CEO, Chair of the Board, secretary and treasurer of Soroban. The debtor was the only employee of Soroban and often did the vast majority of the work operating and generating revenue for Soroban, which included preparing tax returns, signing checks, executing promissory notes and performing consulting services for Soroban’s clients. By contrast, the debtor’s spouse was not responsible for business decisions or reviewing reports. In or around May 2011 and May 2012, Premier Capital, LLC (“Premier”) commenced debt collection efforts against the debtor in connection with judgments Premier had acquired from prior financial lending institutions. The debtor subsequently filed a voluntary petition for relief with the Bankruptcy Court under chapter 7 of the Bankruptcy Code. Interestingly, the debtor listed limited personal property, no cash, the individual consulting business with a value of $0 and limited funds received from Soroban. Premier initiated an adversary proceeding seeking among other things, an order denying the debtor’s discharge under 727(a)(2)(A) of the Bankruptcy Code on the basis that the debtor had transferred and concealed assets during the one-year prepetition lookback period. After trial Judge Lane ruled in favor of Premier with respect to their application to deny the debtor’s discharge. The debtor appealed the Bankruptcy Court’s ruling.
On appeal, the Court examined a debtor’s equitable interest in a business, applying a multi-factor test reviewing (1) whether a debtor previously owned a similar business; (2) whether the debtor left his previous business venture under financial duress; (3) whether the debtor transferred his or her salary, or the right to a salary to a relative or to a business entity owned by a relative; (4) whether the debtor is actively involved in the operational success of the insider business; and (5) whether the debtor retains the benefits of or access to the salary from the business, such as having expenses paid for by the insider-relative of the business. See, e.g., Darwin (Huck) Spaulding Living Trust v. Carl (In re Carl), 517 B.R. 53, 65-66 (Bankr. N.D.N.Y. 2014).With this analysis in mind, Judge Nelson S. Roman affirmed Judge Lane’s application of the multi-factor test set forth in In re Carl and focused on the debtor’s relationship to Soroban to ascertain whether any beneficial interest existed. 517 B.R. 53, at 65-66.
The Court confirmed the debtor’s admission that he had operated a similar business prior to his bankruptcy filing and that he was “under siege” by his creditors when his spouse established Soroban. Next, the Court noted that the debtor left his previous business ventures due to an inability to make money and would later receive an income from Soroban. Further, the debtor was the only employee Soroban, doing everything necessary to operate the business and generate income, including consulting with clients, preparing tax returns, signing promissory notes and determining his own salary. His spouse neither received, reviewed nor executed any business related documents, she only insisted that Soroban not take on any debt. Finally, instead of fixing a regular salary, the debtor used corporate accounts to pay for personal expenses via credit cards and his spouse’s bank account. In the years before the bankruptcy filing, the debtor made representations to creditors that he had no sources of income, no investment or savings accounts and no interests in any business entities.
The Court also cited In re Klutchko noting that, “numerous courts have found that debtors who transferred all of their salary, or their right to receive salary, to a family member or to a corporation owned by a family member, yet retained the benefits of such salary, as here, should be denied a discharge.” In re Klutchko, 338 B.R. 554, 571 (Bankr. S.D.N.Y. 2005). The Court concluded that each of the elements in In re Carl had been met and the debtor had retained a beneficial interest in Soroban, relying on undisputed evidence. The debtor had transferred his right to receive a salary to Soroban but retained the benefits of such a salary insofar as the company paid for the debtor’s household expenses, credit card bills and personal expenses.
After determining the debtor’s equitable interest, the Court turned to the debtor’s intentions to conceal assets, as required under Section 727(a)(2), “plaintiff must demonstrate that the debtor concealed his interest in the subject property.” Ultimately, courts examine the circumstances in which debtors place assets beyond the reach of creditors or refuse to provide information to creditors, and if there is any other legitimate reason for structuring interests as designated. In re Hayes, 229 B.R. 253, 259 (B.A.P. 1st Cir. 199) (Citing Marine Midland Bank v. Portnoy (In re Portnoy), 201 B.R. 685, 694 (Bankr. S.D.N.Y. 1996)). Secondly, “Concealment is ‘evidenced when a debtor withholds knowledge or refuses to divulge information because there is a “duty” once a debtor begins to set forth the facts requested.’” In re Gardner, 384 B.R. 654, 663 (Bankr. S.D.N.Y. 2008). There is a stronger inference of concealment when the debtor “diverts the fruits of his industry to family members, who then provided him with the use and enjoyment of material comforts purchased with those fruits.” In re Carl, 517 B.R. at 67-68 (quoting In re Coady, 588 F.3d 1312, 1316 (11th Circ. 2009)).
In evaluating the debtor’s concealment, the Court noted the undisputed facts that the debtor denied any source of income or interest in any business entity even prior to the petition date, listed zero value for Soroban in his Schedules and Statement of Financial Affairs, and omitted information about his spouse’s income, without credible justification. The overall structure of the debtor’s financial planning reflected “indicia of concealed income, e.g., despite operating Soroban which generated more than $100,000 in income on an annual basis, the debtor maintained no personal bank accounts and instead received monetary benefits indirectly.” On these facts, the Court concluded that the debtor’s “structuring of finances derived from Soroban amounted to an attempt to divert fruits of his industry to family members who then provided him access to that income.”
After determining the debtor’s acts of concealment, the Court sought to analyze the debtor’s intent to hinder creditors by assessing traditional “badges of fraud, ” including (i) lack or inadequacy of consideration; (ii) a family, friendship, or close associated relationship between the parties; (iii) the retention of position, benefit, or use of the property in question; (iv) the financial condition of the party sought to be charged both before and after the transaction in question; (v) the existence or cumulative effect of a pattern or series of transactions or course of conduct after incurring of debt, onset of financial difficulties, or pendency of suit by creditors; and (vi) the general chronology of the events and transaction. In re Gardner, 384 B.R. at 663-64.
Under this framework, the Court confirmed the debtor’s intention to hinder creditors as there were various badges of fraud. Specifically, the first two badges of fraud were met as there was inadequate consideration for transfers made from Soroban to the debtor’s spouse as she performed no actual work for Soroban. The debtor retained benefits of Soroban’s assets to pay for his personal expenses, thereby establishing the third badge of fraud. There were also substantial liabilities against the debtor which influenced how Soroban was structured –the entity was used as a vehicle to allow the debtor to pursue consulting in an effort to hinder creditors from seizing the debtor’s assets. Furthermore, the debtor’s misleading disclosures supported a finding for an intent to conceal assets to hinder creditors.
The Court applied the continuous concealment doctrine because the debtor transferred his right to receive a salary from Soroban continuously before and during the pre-petition period (and the one year period prior to the filing of the debtor’s petition); used Soroban’s income for his personal expenses during the same period and continuously concealed his assets. The Court noted that “a typical continuing concealment claim involves (1) the transfer of property by a debtor who still retains a beneficial interest or equitable interest in the property; and (2) the debtor’s continuing to treat the property in the same manner after the transfer as before the transfer.” In re Shah, No. 07-13833 (SMB), 2010 WL 2010824, at *7 (Bankr. S.D.N.Y. May 13, 2010) (citation omitted). The Court held that “[O]ther Circuits have recognized [the] ‘continuous concealment’ doctrine, pursuant to which a ‘concealment will be found to exist during the year before bankruptcy even if the initial act of concealment took place before this one-year period as long as the debtor allowed the property to remain concealed into the critical year.” In re Boyer, 328 F. App’x 711, 714 (2d Cir. 2009) (quoting Rosen v. Bezner, 996 F.2d 1527, 1531 (3d Cir. 1993)). The debtor’s actions specifically fit this scenario where Soroban had been formed years before the debtor’s bankruptcy filing, the debtor’s acts of concealment began prior to the bankruptcy filing and the debtor retained a beneficial interest in Soroban based on his financial planning that continued well into the critical pre-petition period.
The Court’s decision supports the framework available to creditors and trustees in examining the financial circumstances of debtors and the application of the continuing concealment doctrine. By scrutinizing and closely examining disclosed and undisclosed sources of income and well as entities affiliated with a debtor and his/her family, parties in interest can assess whether assets are being shielded from creditors through bankruptcy. Inquiry into a debtor’s pre-petition correspondence with lenders, misleading tax returns and an entity’s ownership wherein individuals with no experience or training are “managing” business can yield successful results for creditors and help identify fraudulent debtor conduct. Thomas H. Curran Associates LLC’s investigation of this matter yielded successful results for Premier, and the firm is actively engaged in monitoring the development and recognition of the continuing concealment doctrine in courts across the United States.