New Jersey Supreme Court Overturns Appellate Court Ruling on Fraudulent Transfer
The sole shareholder of several closely held corporate entities engages in a fraudulent transfer by extinguishing one entity’s right to payment from a third party in exchange for the release of liabilities owed by other entities to that same third party. In Motorworld, Inc. v. William Benkendorf, et al., __ N.J. __ (Mar. 30, 2017), the New Jersey Supreme Court voided such a transfer against a Chapter 7 debtor corporation whose sole asset was a $600,000 loan receivable purportedly cancelled by the release.
Carole Salkind (“Carole”) was the sole shareholder of multiple closely held corporations, including Motorworld, Inc. William Benkendorf operated a landscaping business, which had provided services to two different Salkind corporations: Fox Development, Inc. (“Fox”) and Giant Associates, Inc. (“Giant”). Over time, Fox and Giant came to owe Benkendorf’s company more than $1,000,000. Separately, Carole and her husband agreed to loan $500,000 to Benkendorf. To effectuate the loan, Carole first loaned $499,000 to Motorworld, which then loaned the money to Benkendorf under a demand note that called for repayment of a principal amount of $600,000. When it became clear that Benkendorf could not repay the loan even after several extensions of the payment date, Carole and her husband negotiated a Release in which Benkendorf agreed to forgo collection of the $1,000,000 owed by Fox and Giant in exchange for the cancellation of his debt to Motorworld. Months after execution of the Release, Carole and her husband each filed Chapter 7 petitions for Bankruptcy. Carole’s petition listed Motorworld, Fox and Giant as among her corporate assets but, consistent with the Release, she did not list the $600,000 Benkendorf loan as an asset of Motorworld.
A Chapter 7 Trustee appointed for Carole’s estate determined that Motorworld “conducted no business, that its $500,000 debt to Carole Salkind was its sole liability, and that it had a single asset: The Benkendorfs’ $600,000 debt to Motorworld.” The Trustee brought two actions against the Benkendorfs: an action in the name of Motorworld to collect on the Note, and a separate action as Trustee for Carole to void the Release as an actual or a constructive fraudulent transfer under the Uniform Fraudulent Transfer Act (“UFTA”), N.J.S.A. 25:2-20, et seq. The trial court found that the evidence did not show that the transaction was an actual fraudulent transfer because it was not meant to hinder or defraud Carole, Motorworld’s creditor. However, the court concluded that the transfer was constructively fraudulent under N.J.S.A. 25:2-27(a) because Motorworld received no “reasonably equivalent value” in return and became insolvent as a result of the transfer. On appeal, the Appellate Division reversed. Although it acknowledged that Motorworld did not benefit, the panel treated Motorworld and its sole shareholder as interchangeable for purposes of the UFTA. Accordingly, the appeals court saw the transfer as benefiting Motorworld’s creditor and sole shareholder, Carole, by absolving two of her other companies (Fox and Giant) of a significant debt, which constituted “reasonably equivalent value.”
The New Jersey Supreme Court reversed. The court read the UFTA strictly to require that the debtor must receive reasonably equivalent value and it was not enough that a creditor of that debtor or even the debtor’s individual shareholder received the value. In the court’s view, the UFTA “should be construed consistently with the ‘basic tenet of American corporate law . . . that the corporation and its shareholders are distinct entities.’” In other words, because Carole’s corporate entities were incorporated and managed as “separate corporate entities,” distinct from their common shareholder, there was “no reason to abandon the corporate form.” Having resolved the question before it, the court remanded to the Appellate Division for consideration of other defenses, including the statute of limitations and equitable defenses to the Trustee’s actions, which had not been considered by the lower courts.
Motorworld is a reminder that, even in the context of closely held corporations, parties must consider carefully each entity’s own assets and liabilities in structuring transactions. Further, as the Court noted, different facts could change the result: for example, had Motorworld itself been indebted to Benkendorf, the release would clearly have benefited Motorworld. Likewise, the Court might have reached a different result had it found grounds to pierce the corporate veil between Carole and her entities, or found that Fox, Giant and Motorworld were not separate entities but rather a single economic unit. And, even if the same debtor were to benefit from the transfer, that would not necessarily resolve the “reasonably equivalent value” issue. Notably, the Court did not discuss whether the release of $1,000,000 contract indebtedness could be reasonably equivalent consideration for the forgiveness of a $600,000 note obligation, leaving that question for a future case.