Spradlin v. Beads & Steeds Inns, LLC (In re Howland)

• Decision Date: 07 June 2016
• Docket Number: CIVIL ACTION NO. 5:14-426-KKC
• Citation: 579 B.R. 411
• Parties: IN RE: Matthew Lowell HOWLAND and Meagan Larae Howland, Debtors, Phaedra Spradlin, Trustee, Appellant, v. Beads and Steeds Inns, LLC, Appellee.
• Court: U.S. District Court — Eastern District of Kentucky

579 B.R. 411

IN RE: Matthew Lowell HOWLAND and Meagan Larae Howland, Debtors,Phaedra Spradlin, Trustee, Appellant,

v.Beads and Steeds Inns, LLC, Appellee.

CIVIL ACTION NO. 5:14-426-KKC

United States District Court, E.D. Kentucky, Central Division. at Lexington.

Signed June 7, 2016

James R. Irving, Bingham Greenebaum Doll LLP, Louisville, KY, Richard Boydston, Bingham Greenebaum Doll LLP, Cincinnati, OH, for Appellant.

Adam Mastin Back, Stoll Keenon Ogden, PLLC, Lexington, KY, for Appellee.

OPINION AND ORDER

KAREN K. CALDWELL, CHIEF JUDGE

The Appellant, Phaedra Spradlin, Trustee, appeals the memorandum opinions and orders [Adv. Doc. 20, 21, 24, 25] entered by the United States Bankruptcy Court, Eastern District of Kentucky, Adv. No. 14–5019, dated August 22, 2014 and October 2, 2014. For the following reasons, the Court affirms both of the Bankruptcy Court's orders.

I. BACKGROUND

The following facts are set forth in the Trustee's Complaint and Amended Complaint. [Adv. Doc 1, 22-1]. On June 20, 2007, the Debtors entered into a contract to purchase approximately 133 acres of real estate located at 9863 Lexington Road, Lancaster, KY 40444 (the "Farm") for $1.6 million (the "2007 Sales Contract"). [Adv. Doc. 22-1, Amended Complaint ¶ 9.]

The Debtors are the sole members of Meadow Lake Horse Park, LLC ("Meadow Lake"). [Adv. Doc. 22-1, Amended Complaint ¶ 8.] On July 19, 2007, the Debtors and Meadow Lake entered into an Assignment in which the Debtors assigned their rights under the 2007 Sales Contract to Meadow Lake. [Adv. Doc. 22-1, Amended Complaint ¶ 10.] The Debtors received no consideration from Meadow Lake for this assignment.

On July 25, 2007, Meadow Lake took out a $1.6 million bank loan to be secured by a mortgage on the Farm. [Adv. Doc. 22-1, Amended Complaint ¶ 11.] The Debtors guaranteed the loan to Meadow Lake. [Adv. Doc. 22-1, Amended Complaint ¶ 11.] On July 26, 2007, the sale of the Farm to Meadow Lake was completed. [Adv. Doc. 22-1, Amended Complaint ¶ 12.]

In November, 2010, the Debtors used proceeds of their personal income tax return to repay approximately $760,000 of Meadow Lake's bank loan. [Adv. Doc. 22-1, Amended Complaint ¶ 15.] Meadow Lake did not give any consideration to the Debtors or promise repayment.

On December 28, 2010, the Debtors, as members of Meadow Lake, executed a Purchase Agreement between Meadow Lake and Beads and Steeds Inns, LLC. [Adv. Doc. 22-1, Amended Complaint ¶ 18.] Under this agreement, Meadow Lake sold the Farm and certain mobile homes located on the Farm to Beads and Steeds for $800,000 ("2010 Transfer"). [Adv. Doc. 22-1, Amended Complaint ¶¶ 18-19.] The Trustee alleges the value of the Farm was much greater at the time of the 2010 Transfer. [Adv. Doc. 22-1, Amended Complaint ¶ 20.]

Following the 2010 Transfer, the Debtors continued to operate the Farm as a horse boarding and training facility, a bed and breakfast, and an event facility. [Adv. Doc. 22-1, Amended Complaint ¶ 25.] Under a lease executed in June, 2011, the Debtors paid Beads and Steeds $1,000 a month to use the Farm and paid for certain expenses. [Adv. Doc. 22-1, Amended Complaint ¶ 27.] The Trustee believes this amount was less than market value. [Adv. Doc. 22-1, Amended Complaint ¶28.]

The Trustee alleges that during all of the above described events, the Debtors disregarded the corporate separateness of Meadow Lake by using vehicles and equipment owned by Meadow Lake for personal use, transferring their interest in the 2007 Sales Contract to Meadow Lake for no consideration, opening a revolving credit line in Meadow Lake's name and using it to incur personal debt, and paying part of Meadow Lake's mortgage with their personal income tax return. [Adv. Doc. 22-1 Amended Complaint ¶¶ 13-17.]

The Debtors filed a Chapter 7 bankruptcy petition on May 8, 2012. [Adv. Doc. 22-1, Amended Complaint ¶ 34.] In their petition, the Debtors listed Meadow Lake as one of "All Other Names used by the Debtor in the last 8 years." [Adv. Doc. 22-1, Amended Complaint ¶ 16.]

On May 6, 2014, the Trustee filed the Complaint in this proceeding against Beads and Steeds, seeking to avoid the 2010 Transfer as a fraudulent conveyance under § 548(a)(1)(B) and K.R.S. § 378.020, via § 544(b). In response, the Defendant moved for judgment on the pleadings for failure to state a claim upon which relief may be granted, arguing that the Trustee only alleged a transfer by Meadow Lake, not the Debtors. [Adv. Doc. 9.] The Trustee countered that under a theory of reverse piercing of the corporate veil, the Debtors and Meadow Lake should be considered one and the same.

In an Opinion and Order dated August 22, 2014, ("August Opinion and Order") the Bankruptcy Court concluded that the Trustee cannot proceed on a reverse veil piercing theory under Kentucky law, but permitted the Trustee to move to amend the Complaint to add a substantive consolidation theory. [Adv. Doc. 20 at 12-13.]

The Trustee moved to amend the complaint [Adv. Doc. 22] and filed the proposed Amended Complaint. In a second Opinion and Order dated October 2, 2014, ("October Opinion and Order"), the Bankruptcy Court found that the Trustee had failed to state a claim for substantive consolidation. [Adv. Doc. 24 at 10-11.] It therefore granted the Defendant's Motion for Judgment on the Pleadings and denied the Trustee's Motion for Leave to File the Amended Complaint. [Adv. Doc. 25.]

The Trustee now appeals the August Opinion and Order as well as the October Opinion and Order.

II. STANDARD OF REVIEW

A federal district court has jurisdiction to hear appeals from "final judgments, orders, and decrees" of the bankruptcy court. 28 U.S.C. § 158(a). The bankruptcy court's legal determinations are reviewed de novo. Darrohn v. Hildebrand (In re Darrohn) , 615 F.3d 470, 474 (6th Cir.2010). A bankruptcy court's decision involving application or interpretation of state law is a conclusion of law reviewed de novo. Merringer v. Schramm (In re Schramm) , 431 B.R. 397, 399 (6th Cir. BAP 2010).

"Motions for judgment on the pleadings pursuant to Fed. R. Civ. P. 12(c) are analyzed under the same de novo standard as motions to dismiss pursuant to Fed. R. Civ. P. 12(b)(6)." Sensations, Inc. v. City of Grand Rapids, 526 F.3d 291, 295 (6th Cir.2008).

The denial of a motion for leave to amend the complaint ordinarily is reviewed for abuse of discretion. Dubuc v. Green Oak Twp., 312 F.3d 736, 743 (6th Cir.2002). However, when denial is on the basis of futility, the decision is reviewed de novo. Id.

III. ANALYSIS

Under KRS § 275.010(2), an LLC is a legal entity distinct from its members, meaning the Debtors and Meadow Lake are separate legal entities. Meadow Lake did not file bankruptcy, so, despite the fact that the Debtors are its sole members, Meadow Lake is not a debtor in this proceeding.

In order to pursue her federal and state fraudulent conveyance claims, the Trustee needs to consolidate the Debtors and Meadow Lake into a single entity. To use § 548, § 544, and K.R.S. § 378.020 to avoid the transfer of the Farm from Meadow Lake to Beads and Steeds, the Trustee must show that the "debtor" participated in the transfer. See 11 U.S.C. § 548(a)(1) ("transfer...of an interest of the debtor in property..."); § 544(b)(1) ("transfer of an interest of the debtor in property"); K.R.S. § 378.020 ("transfer...made by debtor..."). Put simply, Meadow Lake is the entity that made the transfer, but it is not the "debtor." The Trustee is attempting to use either a reverse veil piercing or substantive consolidation theory to disregard the separate existence of Meadow Lake and thereby treat the 2010 Transfer as if it were made by the Debtors. However, the Trustee cannot successfully rely on either theory to reach her desired result.

A. Reverse Veil Piercing

The Trustee may not use reverse veil piercing to consolidate the Debtors and Meadow Lake under Kentucky law as it currently exists. Kentucky Courts have yet to officially adopt reverse veil piercing. Furthermore, even if reverse veil piercing was accepted in Kentucky, it is reasonable to believe that it would be employed only as a remedy to allow creditors recovery against the assets of a business entity, rather than a means of consolidating a business entity with its separate owners. Therefore, the Trustee stretches too far in her attempted use of reverse veil piercing under current Kentucky law.

Courts are "deeply split" in accepting reverse veil piercing. ALT Hotel, LLC v. Diamondrock Allerton Owner, LLC (In re ALT Hotel, LLC) , 479 B.R. 781, 801 (Bankr.N.D.Ill.2012). "A 'significant minority' of courts reject outside reverse piercing...and courts 'are overwhelmingly hostile' to insider reverse piercing." Id. at 801–02 (citing 1 Philip I. Blumberg, et al., Blumberg on Corporate Groups § 10.02 at 14-29, 14-22 (2007 Supp.)). Indeed, reverse veil piercing is not without its critics. See Postal Instant Press, Inc. v. Kaswa Corp., 162 Cal.App.4th 1510, 77 Cal.Rptr.3d 96, 105 (2008) ("conversion and fraudulent conveyance already afford judgment creditors protection...[o]utside reverse piercing is an unacceptable shortcut to pursue those remedies."); Acree v. McMahan , 276 Ga. 880, 585 S.E.2d 873, 875 (2003) ("Allowing outsider reverse piercing claims would constitute a radical change to the concept of piercing the corporate veil in this state and, thus, should be created by the General Assembly and not by this Court."). Reverse veil piercing is by no means a widely accepted legal principle.

There are two recognized types of reverse veil piercing—insider and outsider. Insider reverse veil piercing allows a shareholder to disregard the corporation of which he is a part for his own benefit. Hibbs v. Berger , 430 S.W.3d 296, 310 (Mo.Ct.App.2014). On the other hand, outsider veil piercing occurs where a third-party creditor seeks to reach the assets of a corporation to satisfy the debts of a corporate insider. Grimmett v. MccCoskey (In re Wardle) , 2006 WL 6811026, *6, 2006 Bankr. LEXIS...