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Third Circuit Rules That Transfer by Nondebtor Is Not Avoidable as Fraudulent Transfer Under Delaware UFTA

May/June 2018

In Crystallex International Corp. v. Petróleos de Venezuela, S.A., 879 F.3d 79 (3d Cir. 2018), a divided U.S. Court of Appeals for the Third Circuit ruled that transfers by nondebtor subsidiary corporations to their ultimate parent corporation, which was alleged to be the Republic of Venezuela’s alter ego, were not fraudulent transfers under the Delaware Uniform Fraudulent Transfer Act ("DUFTA"). The panel reversed a district court ruling declining to dismiss a cause of action to recover a judgment against Venezuela by avoiding transfers of funds out of the U.S. by entities allegedly controlled by the Venezuelan government. The Third Circuit ruled that the nondebtor transfers at issue could not be deemed fraudulent transfers under the language and structure of DUFTA.

The Delaware Uniform Fraudulent Transfer Act

Like section 548 of the Bankruptcy Code, state laws generally patterned on the Uniform Fraudulent Transfer Act (now known as the Uniform Voidable Transactions Act) provide for the avoidance of transfers or obligations that are actually or constructively fraudulent. For example, DUFTA provides that:

A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation . . . [w]ith actual intent to hinder, delay or defraud any creditor of the debtor [or] [w]ithout receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor [is or was rendered insolvent].

Del. Code Ann. tit. 6, § 1304(a) (West 2018) (emphasis added).

Crystallex

Canadian mining company Crystallex International Corp. ("Crystallex") owned the rights to a gold reserve in Venezuela. In 2011, Venezuela nationalized the country’s gold mines and confiscated Crystallex’s rights in the gold reserve. Thereafter, Crystallex initiated an arbitration proceeding against Venezuela in the World Bank. Finding that Venezuela had violated an investment treaty with Canada, the arbitrators awarded Crystallex $1.2 billion. The U.S. District Court for the District of Columbia confirmed the arbitration award in 2017.

PDV Holding, Inc. ("PDVH") and CITGO Holding, Inc. ("CITGO Holding" and, collectively, the "defendants"), both Delaware corporations, are direct or indirect subsidiaries of Petróleos de Venezuela, S.A. ("Petróleos"), a state-owned Venezuela company. According to Crystallex, Petróleos, which is Venezuela’s alter ego, caused CITGO Holding to issue $2.8 billion in debt, the proceeds of which were later paid to its parent company, PDVH, as a dividend. PDVH then transferred this sum farther up the ladder and out of the U.S. by issuing a dividend in the same amount to its own parent, Petróleos. Crystallex alleged that this series of events was carried out in order to repatriate funds to Venezuela, where they would be safe from execution by U.S. creditors.

Crystallex sued the defendants in the U.S. District Court for the District of Delaware, seeking, among other things, to avoid the loan and dividend transaction under DUFTA as a fraudulent transfer. The defendants moved to dismiss the complaint, arguing that there was no "transfer" made under DUFTA because the transaction did not involve "property of" the judgment debtor (i.e., Venezuela or its alter ego, Petróleos) and that accordingly there was no relevant transfer made "by a debtor." In particular, they contended, because neither Venezuela nor Petróleos had any direct ownership interest in the defendants’ assets, no "transfer" of debtor property occurred. By contrast, Crystallex urged the court to look at the "economic reality" of the transactions, arguing that the extraction of value by Venezuela’s alter ego, Petróleos, from its subsidiaries diminished the value of Petróleos’ equity interest in those subsidiaries and therefore qualified as a "transfer" of a debtor’s property under DUFTA.

Initially, the district court noted that the Delaware Supreme Court (Delaware’s highest court) has not ruled on whether a transfer by a nondebtor can be avoided under DUFTA. For this reason, the district court explained, the federal court’s role is to predict how the state court would rule.

After examining the statute and relevant case law, the district court acknowledged that Crystallex’s fraudulent transfer claim "strains the statute’s structure." Even so, the court ruled that because the complaint alleged that property was transferred "at the debtor’s behest," it properly alleged the existence of a fraudulent transfer under DUFTA. However, although the court concluded that PDVH, as a nondebtor transferor of debtor property, was an appropriate defendant, the court dismissed CITGO Holding from the case because it was not a party to a fraudulent transfer under DUFTA and could not be held liable as an accomplice or coconspirator. PDVH appealed the decision.

The Third Circuit’s Ruling

A divided three-judge panel of the Third Circuit reversed.

The Third Circuit majority looked to other Delaware state courts for guidance. In particular, the Delaware Court of Chancery ruled in both Edgewater Growth Capital Partners v. H.I.G. Capital, Inc., 2010 WL 720150 (Del. Ch. Mar. 3, 2010), and In re Wickes Trust, 2008 WL 4698477 (Del. Ch. Oct. 16, 2008), that transfers by nondebtors cannot be avoided under DUFTA.

In addition, the Third Circuit majority noted that the Delaware Chancery Court and federal courts interpreting federal and Delaware law have also rejected fraudulent transfer claims against nondebtor transferors under the analogous provision of the Bankruptcy Code (i.e., section 548). See Spring Real Estate, LLC v. Echo/RT Holdings, LLC, 2016 WL 769586 (Del. Ch. Feb. 18, 2016), aff’d, 2016 WL 7189917 (Del. Dec. 12, 2016) (rejecting a fraudulent conveyance claim against a nondebtor subsidiary of the debtor parent company); Brandt v. B.A. Capital Co. (In re Plassein Int’l Corp.), 366 B.R. 318 (Bankr. D. Del. 2007), aff’d, 388 B.R. 46 (D. Del. 2008), aff’d, 590 F.3d 252 (3d Cir. 2009) (dismissing state and federal fraudulent transfer claims because the allegedly fraudulent transfer was made by a nondebtor).

The majority underscored that Crystallex did not allege that PDVH was a debtor or otherwise liable for the judgment Crystallex obtained against Venezuela. Instead, Crystallex characterized the transfers as being to, rather than by, the debtor, a circumstance that in the Third Circuit’s view DUFTA does not contemplate.

The majority rejected a broad reading of the language "by the debtor" which would encompass a nondebtor subsidiary transferor (like PDVH) because such a construction would undermine Delaware corporate law’s fundamental principle that parent and subsidiary corporations are separate legal entities. In addition, on the basis of the facts alleged by Crystallex, the Third Circuit was unwilling to disregard PDVH’s distinct corporate identity.

The Third Circuit majority also rejected Crystallex’s arguments that DUFTA’s "broad remedial purpose" required a finding that the transactions at issue were fraudulent and that, because the intent of the series of transactions was to hinder creditors, equitable considerations mandated that it be subject to avoidance under the statute. The court wrote that "having broad latitude to craft a remedy for a DUFTA violation does not necessarily mean we have broad latitude to determine what fits within the contours of the statute in the first place." Moreover, it explained, Delaware’s Chancery Court (a court of equity) had the opportunity to conclude, as a matter of equity, that DUFTA covers transfers by nondebtors but has not done so.

Finally, relying on Delaware court rulings invalidating theories of non-principal or aiding and abetting liability under DUFTA, the Third Circuit majority rejected the argument that DUFTA should apply to nondebtor transfers which are "orchestrated" by a debtor.

Accordingly, the Third Circuit reversed the district court’s order and remanded the case below for further proceedings.

Circuit judge Fuentes dissented, writing that the majority misconstrued the language and purpose of DUFTA as well as the case law construing it. According to Judge Fuentes:

[T]oday the majority signals that a party, such as [PDVH], may knowingly participate in a fraudulent transfer so long as it is not a debtor. Indeed, a consequence of the majority’s holding is that, under [DUFTA], a foreign sovereign—such as Venezuela—is free to fraudulently repatriate assets, so long as the party making the transfer is a non-debtor. That result does not comport with—but rather is wholly contrary to—the Act’s broad remedial purpose.

On February 5, 2018, the Third Circuit denied Crystallex’s motion for reconsideration.

Outlook

Crystallex illustrates that, although the ability to avoid fraudulent transfers is an important tool for both creditors and bankruptcy trustees, the remedy is limited to cases where the debtor transfers property or incurs an obligation either with the intent to defraud creditors or under circumstances meeting the element of constructive fraud. According to the Third Circuit majority, even though the transactions at issue may have been fraudulent, avoidance under DUFTA was not the proper remedy for the fraud because the judgment debtor (Venezuela) did not transfer any property.

While the result is undeniably frustrating for Crystallex—and, according to the dissent, contrary to the spirit of the avoidance statute—it does not preclude other avenues of attack. For example, Crystallex could argue that, because the subsidiary transferors were alter egos or mere instrumentalities of Venezuela, they should be deemed to be the "debtor[s]" for purposes of the statute. Moreover, creditors of the U.S. subsidiary transferors could conceivably file involuntary bankruptcy cases against the subsidiaries under an alter ego theory, and federal and state law claims could be asserted in those bankruptcy cases to avoid the upstream transfers. Because the funds have already been harbored in Venezuela, recovery on such avoidance claims may be difficult.

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