The Scylla of Twombly/Iqbal and the Charybdis of FRCP 15: The Challenges of Pleading Fraudulent Transfer Claims ‘In the Alternative’

It is commonplace for complaints alleging avoidance claims to be filed on the eve of the expiration of the two-year statute of limitations imposed by Bankruptcy Code Section 546(a). Especially when the plaintiff is not a reorganized debtor but is instead a liquidating trustee or other estate representative, familiarity with the prepetition dealings between the debtor and potential defendants often is minimal.

As a consequence, a practice of pleading “in the alternative” that a prepetition transfer that is nominally a preference also is a fraudulent transfer has developed. ¹Steven S. Flores, Pleading in the Alternative: Emerging Bankruptcy Court Trends After Twombly and Iqbal, 2011 No. 5 Norton Bankr. L. Adviser 2. This had been viewed as a prudent step, even if the risk was small that a later amendment to add a fraudulent transfer claim would be denied as untimely because the claim does not relate back to the timely-filed preference claim. However, this formerly prudent step may run afoul of the pleading standards recently articulated by the Supreme Court in Twombly
²Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 566 (2007). and Iqbal, ³Ashcroft v. Iqbal, 129 S.Ct. 1937, 1953, 173 L. Ed. 2d 868 (2009). and the growing number of lower court cases interpreting Rule 8 of the Federal Rules of Civil Procedure (FRCP 8) in light of the Supreme Court’s decisions.

This article discusses the circumstances typically confronted by plaintiffs who are preparing to file avoidance complaints, the “relation back risk” they face if they do not plead a fraudulent transfer claim “in the alternative,” the challenges posed by the Supreme Court’s Twombly and Iqbal decisions when pleading a fraudulent transfer claim in the alternative, and finally how plaintiffs may chart a safe course between relation back risk and the pleading standards articulated in Twombly and Iqbal.

Circumstances Confronted by Plaintiffs Preparing To File Avoidance Complaints

Avoidance claims can be a significant source of recovery for creditors in Chapter 11 bankruptcy cases. While these claims can be pursued by the debtor in possession during the pendency of its case, or by the reorganized debtor after confirmation of a plan, they often are transferred pursuant to a Chapter 11 plan to a liquidating trust, the trustee of which is charged with pursuing the claims for the benefit of the trust’s beneficiaries—typically, the debtor’s unsecured creditors. Nor is it uncommon for adversary complaints to be filed only weeks or even days before the two-year statute of limitations of Section 546(a) expires. ⁴11 U.S.C. §546(a) (“An action or proceeding under section 544, 545, 547, 548, or 553 of this title may not be commenced after the earlier of – … 2 years after the entry of the order for relief … .”). The reasons for this will vary from case to case. The debtor may be fully occupied with its restructuring efforts, or it may be reluctant to sue creditors with whom it continues to do business. Alternatively, the debtor may anticipate from the inception of its case that avoidance claims will be pursued not by it but by a committee or trustee.

The challenges of filing numerous adversary complaints in the face of a fast-approaching statute of limitations include reviewing the debtor’s financial records to determine what transfers may be avoided, based on which causes of action, and from whom. Depending on the circumstances of the case, the plaintiff may not have access to all of the debtor’s financial records, or the records may be incomplete or difficult to interpret, and in either event the plaintiff may not have the benefit of the debtor’s employees’ institutional knowledge about the debtor’s prepetition transfers. Accordingly, the plaintiff often finds itself in a situation in which the debtor’s financial records indicate that a party received a payment from the debtor, but the plaintiff will not know whether the transfer otherwise meets all of the elements of a preference or fraudulent transfer claim, or is subject to a complete defense.

‘Relation Back Risk’ and the Practice of Pleading ‘In the Alternative’

Faced with these challenges, plaintiffs often are forced to choose between filing adversary complaints asserting only preference claims with the anticipation that they will amend to assert fraudulent transfer claims if warranted by post-filing investigation or discovery, or asserting fraudulent transfer claims “in the alternative” consisting of little more than mere recitals of the elements of the cause of action taken directly from the statute. ⁵Flores, 2011 Norton Bankruptcy Law Adviser 2. Given that adversary complaints asserting preference claims often are filed as the limitations period of Section 546(a) is about to expire, plaintiffs choosing the first option must be confident that such an amendment would relate back to the date of the original complaint under Rule 15(c) of the Federal Rules of Civil Procedure (FRCP 15). ⁶FRCP 15, which is made applicable to adversary proceedings pursuant to Rule 7015 of the Federal Rules of Bankruptcy Procedure, governs amended pleadings. Where a plaintiff seeks to amend its complaint after the running of the applicable statute of limitations and the amendment is more than 21 days after the defendant has filed a responsive pleading, the amendment will be time-barred unless it relates back to the date of the original complaint. Fed. R. Civ. P. 15(c) (“an amendment of a pleading relates back to the date of the original pleading when … (2) the claim or defense asserted in the amended pleading arose out of the conduct, transaction, or occurrence set forth or attempted to be set forth in the original pleading.”). As one treatise explains “[t]he rationale of allowing an amendment to relate back is that once a party is notified of litigation involving a specific factual occurrence, the party has received all the notice and protection that the statute of limitations requires.” 3 Moore’s Federal Practice, §15.19[1] (Matthew Bender 3d ed.).

“Most courts addressing the issue of relation back in the context of preferential transfer and fraudulent conveyance theories have allowed a plaintiff to amend its original complaint alleging a theory of preferential transfer to add or change the theory to fraudulent conveyance theory under Section 548 if the fraudulent conveyance theory stemmed from the same basic transaction or core of operative facts.” ⁷In re Integrated Agri, Inc., Adv. No. 03-8231, 2007 WL 605018, *3 (Bankr. C.D. Ill 2007) (internal citations omitted); see also, In re G. Survivor Corp., 217 B.R. 433, 438 (Bankr. S.D.N.Y. 1998) (authorizing amendment of a preference complaint to add a fraudulent conveyance count because “the proposed amendment is based on the same facts surrounding the transfer …”). However, a number of courts have denied leave to amend a timely-filed preference complaint to allege a fraudulent transfer claim even where the same transfer was at issue. ⁸Smith v. Porter, 416 B.R. 264, 268-69 (E.D. Va. 2009); In re TML, Inc., 291 B.R. 400, 431-32 (Bankr. W.D. Mich. 2003); Coan v. Meryl Diamond, Ltd. (In re Gantos, Inc.), 283 B.R. 649, 651 (Bankr. D. Conn. 2002). As one court explained, “even if the new theory will lead to the same result, e.g. avoidance of the transfer, an amendment cannot relate back if different facts are essential to reach that conclusion” and a fraudulent transfer claim requires consideration of the value of the transfer and other facts materially different from those considered in connection with a preference claim. ⁹In re TML, Inc., 291 B.R. at 431-32.

Therefore, while the risk that leave to amend a timely-filed preference complaint to assert an otherwise untimely fraudulent transfer claim will be denied is not great, neither is it non-existent. Given this, it is understandable that the practice of pleading fraudulent transfer claims “in the alternative” to preference claims would develop, and even become commonplace. However, while this practice may have offered protection from “relation back risk,” after the Supreme Court’s decisions in Twombly and Iqbal there is serious doubt whether a plaintiff can assert a fraudulent transfer claim “in the alternative” that consists of little more than mere recitals of the elements of the cause of action taken directly from the statute while meeting the pleading standards of FRCP 8.

The Challenges Posed by the Supreme Court’s Twombly and Iqbal Decisions

Prior to the Supreme Court’s decisions in Twombly and Iqbal, federal courts consistently held that a complaint was sufficient so long as it put the defendant on notice of the gravamen of the plaintiff’s claims and included the “short and plain statement of the claim showing that the pleader is entitled to relief” called for by FRCP 8. ¹⁰Conley v. Gibson, 355 U.S. 41, 47-8 (1957). However, in its Twombly and Iqbal decisions, the Supreme Court articulated a more demanding, two-pronged test for determining whether a complaint satisfies the pleading standards of FRCP 8.

First, the court must “identify[] the allegations in the complaint that are not entitled to the assumption of truth.” In so doing, “the tenet that a court must accept as true all of the allegations contained in a complaint is inapplicable to legal conclusions. Threadbare recitals of the elements of a cause of action, supported by mere conclusory statements, do not suffice.” ¹¹Iqbal, 129 S.Ct. at 1949-50 (citing Twombly 550 U.S. at 555). Second, the court must evaluate whether the well-pleaded allegations “plausibly suggest an entitlement to relief.” ¹²Iqbal, 129 S.Ct. at 1951. To pass this test, “a complaint must contain sufficient factual matter, accepted as true, to ‘state a claim for relief that is plausible on its face.’” ¹³Iqbal, 129 S.Ct. at 1949 (quoting Twombly 550 U.S. at 570). “A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” ¹⁴Iqbal, 129 S.Ct. at 1949.

Neither Twombly nor Iqbal concerned the pleading of avoidance claims. However, courts were quick to apply the Supreme Court’s holdings in the bankruptcy context. In Pillowtex, the plaintiff alleged in his complaint that the defendant was liable for receiving preferential transfers or “in the alternative” was liable for receiving fraudulent transfers. ¹⁵Wahoski v. Classic Packaging Co. (In re Pillowtex Corp.), 427 B.R. 301, 302-07 (Bankr. D. Del. 2010). The fraudulent transfer claim was plead with very few facts and was only filed “in the alternative” in the event that the plaintiff was unable to proceed on its preferential transfer claim. ¹⁶Id. at 303. The defendant filed a motion to dismiss the fraudulent transfer claim pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure. ¹⁷Id. at 303-04. The court granted the motion and dismissed the fraudulent transfer claim, reasoning that “a plaintiff’s obligation to provide the ‘grounds’ for his ‘entitle[ment] to relief requires’ more than labels and conclusions and a formulaic recitation of the elements of a cause of action will not do. ‘[I]t is clear that conclusory or ‘bare-bones’ allegations will no longer survive a motion to dismiss….’” ¹⁸Id. at 310 (internal citations omitted). Similarly, in Hydrogen and Charys Holding Co., among other cases, courts applied the holdings of Twombly and Iqbal to dismiss avoidance claims that were plead “in the alternative” and contained only minimal factual allegations. ¹⁹Official Committee of Unsecured Creditors of Hydrogen, LLC v. Blomen (In re Hydrogen, LLC), 431 B.R. 337, 352-54 (Bankr. S.D.N.Y. 2010); Charys Liquidating Trust v. Hades Advisors, LLC (In re Charys Holding Co.), Adv. No. 10-50211, 2010 WL 2788152 *3 - *5 (Bankr. D. Del. July 14, 2010).

While the plaintiffs in Pillowtex, Hydrogen, and Charys were given leave to amend, ²⁰In re Pillowtex Corp., 427 B.R. at 311-12; In re Hydrogen, LLC, 431 B.R. at 363; In re Charys Holding Co., 2010 WL 2788152 *4 - *5. a recent unpublished decision suggests that plaintiffs may no longer be routinely afforded a second chance to properly plead an avoidance claim. In Homebanc Mortgage the court granted the defendant’s motion to dismiss the Chapter 7 trustee’s complaint asserting various avoidance claims, explaining that “the complaint … was clearly a form complaint, merely parroting statutory language.” ²¹Miller v. Alston & Bird LLP (In re Homebanc Mortgage Corp.), Adv. No. 10-50621 (Bankr. D. Del. Oct. 29, 2010) (unreported). And while the court gave the trustee the opportunity to amend his complaint, it warned future plaintiffs that it would not be so lenient in the future:

“I am not unmindful of the magnitude of the task sometimes faced by chapter 7 trustees (after conversion of a large chapter 11 case) or of those charged post-confirmation with the duty to pursue avoidance actions … However, pleading requirements in preference suits must be met, a view consistently expressed by the members of this Bench … I have granted the trustee’s request for leave to amend, but with the caution that with respect to deficient form preference complaints filed after today, plaintiffs should expect no such accommodation.” ²²Id.

Nor is dismissal of a complaint that inadequately pleads a fraudulent transfer claim “in the alternative” the only risk rule by avoidance claim plaintiffs. Courts also may impose sanctions pursuant to Rule 11 of the Federal Rules of Civil Procedure in cases where plaintiffs fail to conduct a reasonable pre-filing investigation into the factual and legal basis of their claims. ²³See, e.g., Kaye v. D’Amato, 357 Fed. App. 706, 717 (7th Cir. 2009) (awarding sanctions where plaintiff failed to plead sufficient factual basis for RICO claims); see also Timmons v. Linvatec Corp., 263 F.R.D. 582, *10 (C.D. Cal. 2010) (observing that “allowing plaintiffs to file first and investigate later would be contrary to Rule 11(b)” and awarding sanctions).

Advice for Plaintiffs Preparing to File Avoidance Complaints

After the Supreme Court’s decisions in Twombly and Iqbal, plaintiffs preparing to file avoidance complaints must navigate between “relation back risk” if they choose to assert only a preference claim and the danger of having their fraudulent transfer claim dismissed if they plead that claim “in the alternative” with little more than a mere recital of the elements of the cause of action.

Given the time constraints that frequently exists in avoidance litigation, the best advice for plaintiffs may be the hardest to follow. That is, plaintiffs should begin their pre-filing investigation early, and document the steps taken to investigate avoidance claims. If access to the debtor’s financial records and employees is limited, plaintiffs should seek formal discovery pursuant to Rule 2004 of the Federal Rules of Bankruptcy Procedure.

If time does not permit adequate pre-filing investigation, or if pre-filing investigation is ongoing when the limitations period of Section 546(a) expires, plaintiffs should continue with their investigation and discovery efforts and when warranted amend their original complaints as of right pursuant to FRCP 15(a)(1)(A). Similarly, where local procedural rules or orders do not prohibit it, plaintiffs should consider serving discovery requests with their original complaints, review defendants’ answers and discovery responses promptly, and where they indicate a basis for asserting a fraudulent transfer claim amend as of right pursuant to FRCP 15(a)(1)(B).

Lastly, plaintiffs may be able to guard against “relation back risk” while steering clear of Twombly and Iqbal concerns by asserting only a preference claim in their original complaints, but including allegations as to value and solvency based on information and belief in order to put defendants on notice that a fraudulent transfer claim may later be added. This will give notice to the defendant so that an amended complaint will relate back, but will not assert a deficient claim subject to dismissal.