BAP holds that settlement funded by debtor’s affiliates not a preferential transfer by debtor

| Aug 12, 2013 | Firm News

The First Circuit Bankruptcy Appellate Panel has held that a settlement of claims against the debtor funded by the debtor’s affiliated company and investors is not a preferential transfer to the creditor.

The debtor, Freaky Bean Coffee Company (“Freaky Bean”), operated two coffee shops and a coffee roastery in Maine.  The creditor, Maine Roasters Coffee, operated five coffee shops and a coffee roastery.  Freaky Bean and Maine Roasters entered into an agreement whereby Freak Bean, through an newly created affiliate, MRC Holdings, would purchase substantially all of Maine Roasters’ assets.  MRC assumed liability for two promissory notes totalling $319,000 given by Maine Roasters to Milo Enterprises and Razel Dazel, LLC.  MRC gave Milo and Razel Dazel first priority security interests in all its assets. Freaky Bean also guaranteed MRC’s obligations to Milo and Razel Dazel.  A certain Stratton was president of both Freaky Bean and MRC.

MRC also issued membership units of which 92 percent went to Freaky Bean and 8 percent went to Milo and Razel Dazel.  Milo’s president, a certain Male, was made an “honorary” member of Freaky Bean’s Board of Managers.  However, he never participated in any day-to-day management of Freaky Bean.

Milo and Razel Dazel subsequently declared Freaky Bean and MRC in default of their respective obligations under the notes and guaranteed, made demand for payment and repossessed their collateral in the possession of MRC.  MRC and Freaky Bean entered into a settlement agreement with Milo and Razel Dazel under which the latter would release the former from any deficiency balance upon the payment of approximately $126,000 to Milo, Razel Dazel and certain creditors of Milo and Razel which held the promissory notes assumed by MRC.

The original plan was to form a new company, Beanco, owned by Freaky Bean’s shareholders, and have it fund the settlement with funds provided by the shareholders.  For whatever reason, the shareholders did not complete this plan but instead provided checks directly to Milo or to Stratton personally who caused the funds to be paid to Milo.

An involuntary Chapter 7 bankruptcy was filed against Freaky Bean 91 days after the first payment to Milo and within 90 days of the other payments.  The trustee subsequently filed an adversary proceeding against Milo alleging the settlement payments were preferential transfers.  After an evidentiary hearing, the bankruptcy court found the payments were made for the benefit of Freaky Bean within the 90 day preference period because all the checks cleared within that period.

On appeal by Milo, the BAP first noted that Section 547(b) of the Bankruptcy Code allows the trustee to “avoid any transfer of an interest of the debtor in property,” but the Code does not define “property of the debtor.”  The Supreme Court has held that in this context, “property of the debtor” is “best understood as that property that would have been part of the estate had it not been transferred before the commencement of bankruptcy proceedings.”  Begier v. Internal Revenue Serv., 496 U.S. 53, 58 (1990).  The First Circuit has said that when making this analysis, “the ability of the debtor to exercise control over the property can be determinative.”  In re Reale, 584 F.3d 27, 31 (1st Cir. 2009).

The BAP said there was no evidence that Freaky Bean exercised ownership or control over the settlement funds.  None of the checks were made payable to it or deposited in its accounts.  The funds came from sources that were not Freaky Bean assets.  Although Stratton was the president of Freaky Bean he was also the president of MRC and could act as its agent.  Although the funds were clearly for the benefit of the debtor, there was no evidence that they were ever the property of the debtor.

Accordingly, the BAP reversed the judgment of the bankruptcy court and remanded for further proceedings consistent with its opinion.

The Freaky Bean Coffee Company v. Milo Enterprises, Inc., 2013 WL 3964992 (B.A.P. 1st Cir. Aug. 2, 2013).

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